Co-Authored by: Artem Kobzev
* This article only deals with US corporations and is not applicable to US individuals
An unlimited liability corporation (“ULC”) is a unique corporate structure in which shareholders may incur personal liability for debts and liabilities of the corporation. While this may seem counterintuitive to the normal purpose of incorporation, ULCs are often employed by US businesses as an investment vehicle to the Canadian market due to preferential tax treatment. Specifically, since US tax authorities treat ULCs as “flow through” entities, this allows income and loses to be passed on to the parent company.
What is an Unlimited Liability Corporation (ULC)?
A ULC is a distinct form of corporation available by statute in Alberta, British Columbia and Nova Scotia. The word “unlimited” implies that liability is not limited to assets of the corporation and shareholders personal assets may also be seized to pay debts incurred by the ULC. In British Columbia and Nova Scotia, on dissolution of the ULC, the shareholders and potentially previous shareholders may be liable for obligations of the ULC. In Alberta, dissolution is not required for shareholders to be liable. In general, former shareholders of less than one year may also be liable as well.
Canadian Subsidiaries and Branches
When a US company decides to expand to Canada, it must choose between opening a branch or subsidiary. A branch simply means the US company begins operations in Canada, with the US company subject to Canadian tax obligations. Whereas a subsidiary is the formation of a separate corporate entity in a Canadian jurisdiction.
Active business income earned by non-residents is taxable at the rates applicable to Canadian residents under Part I of the Income Tax Act (Canada) (the “Tax Act”). If a US company carries on business in Canada through a branch, in addition to Part I tax on the business profit, the Tax Act imposes an additional 25% “branch tax”, designed to prevent foreign corporations from avoiding Canadian withholding tax on dividends by carrying on business through a branch as opposed to a corporation. Activities that do not constitute carrying on business in Canada are taxable under Part XIII of the Tax Act. Part XIII tax is a withholding tax that applies to non-resident taxpayers who receive payments of interest, rent, royalty or dividends from Canadian residents. The Part XIII withholding rate is 25%, subject to a reduction in accordance with the Canada-US Tax Convention (the “Tax Treaty”).
To avoid certain measures of the withholding tax regulations, US businesses often form a Canadian corporate subsidiary as the Canadian entity would be a resident of Canada. Further, only the Canadian subsidiary would be responsible for Canadian tax obligations, such as filing an income tax return and comping with provincial sales tax regulations.
In essence, a Canadian corporate subsidiary of a US company will be subject to Part I tax and would pay Canadian taxes associated with its earning in Canada. With respect to distributions, and subject to anti-deferral provisions that apply to controlled foreign affiliates, a US shareholder of a Canadian corporate subsidiary is generally not taxed on the corporate earnings until the earnings are distributed. Once distributed, the US shareholder pays US tax on the dividend received.
Provincial Residency Requirements for Directors
In the provinces of Ontario, Alberta, Newfoundland, New Brunswick and Saskatchewan the majority of a corporation’s directors must be Canadian. In British Columbia, Quebec, New Brunswick, Nova Scotia, Prince Edward Island, Yukon, Northwest Territories the residency requirements vary, but the majority od directors do not need to be Canadian. In particular, in British Columbia, there is no Canadian residency requirement for any directors and ULCs are available. In Ontario, there have been discussions on changing the residency requirements of directors.
For Canadian income tax purposes, ULCs are treated as ordinary corporations. As such, income resulting from interest, dividends, royalties, and other payments from a Canadian ULC to a foreign shareholder may still be subject to a 25 percent Part XIII withholding tax described earlier. Until recently, the Tax Treaty reduced the 25% withholding rate on payment from Canadian ULCs to 5% with the rationale being that for the purposes of US tax law, a ULC is a disregarded entity (not viewed as a separate legal entity from its owner). Due to the implementation of recent hybrid rules, the 5% withholding rate can only be obtained for dividend payments and only if certain steps are followed and certain conditions are met.
US Citizens in Canada
Going back to the anti-deferral provisions that apply to controlled foreign affiliates, US anti-deferral regimes create so called phantom income. The passive foreign income corporation (“PFIC”) is one example of such regimes. For US tax purposes, a corporation will be considered a PFIC if:
- at least 75% of the corporation’s gross income is passive in nature, or;
- at least 50% of the corporation’s assets are investments which produce income in the form of earned interest, dividends or capital gains.
As a result of these rules, if a corporation is found to be a PFIC, its income may be treated as ordinary income for US tax purposes. These rates can be significantly higher than Canadian tax rates for certain types of income (capital gains or dividends) and any tax owing may subject to an interest charge.
One strategy that have been used by many cross-border practitioners is to convert a PFIC into a ULC.
For more information, please call Barbara Hendrickson at BAX Securities Law (416) 601 -1004 or Ray Luckiram at (416) 601-0591.
Publication is not intended to constitute legal advice. No one should act on it or refrain from acting on it without consulting with a lawyer. BAX does not warrant or guarantee the accuracy or currency or completeness of the publication. No part of this publication may be reproduced without the prior written permission of BAX Securities Law.