Canadian unlimited liability companies ("ULCs") have been used for some time now by US-resident investors into Canada for a variety of reasons, including to finance Canadian activities. The benefit from the use of ULCs results from their hybrid nature. Although viewed as regular corporate bodies in Canada, ULCs may be treated as fiscally transparent entities in the US. Moreover, payments made from ULCs to US-resident investors, such as interest and dividend payments, generally benefit from reduced withholding tax rates under the Canada-US Tax Convention (the "Treaty").
As of January 1, 2010 new anti-hybrid rules will come into force that will seriously jeopardize the tax effectiveness of structures using fiscally transparent ULCs. Under new paragraph IV(7)(b) of the Treaty, if (i) a US person is considered under the tax laws of Canada to have received an amount from a ULC that is resident in Canada, and (ii) by reason of the ULC being treated as fiscally transparent under the law of the US, the treatment of the amount under the taxation law of the US is not the same as its treatment would be if the ULC were not treated as fiscally transparent under the law of the US, then the amount will not be considered to have been received by a resident of the US. In such a case, payments received from fiscally transparent ULCs would lose the benefit of the reduced withholding tax rates under the Treaty, and be subject to the general 25% Canadian domestic withholding tax rate.
It seems that these anti-hybrid measures were introduced into the Treaty as a result of the increasing use of financing structures between Canada and the US utilizing hybrid entities such as ULCs, which structures the Canadian and US tax policy makers considered to be inappropriate. However, the impact of these measures will extend to more conventional, and arguably benign, structures such as a simple investment by a US person directly into a ULC. While Canadian and US tax policy officials have indicated some sympathy for this view, there does not appear to be much hope that further changes to the Treaty can or will be introduced before 2010 in order to avoid these impacts. As a consequence, US-resident investors into Canada may want to consider other options. Below are some of the potential alternatives that may be considered.
One alternative that should be considered would be to interpose a foreign intermediary in current structures into Canada. The foreign intermediary could be formed in a country with which Canada has a tax treaty and that has a favorable domestic tax regime for holding corporations, such as the Netherlands or Luxembourg, and could act as a holding company for ULCs. In addition to treaty benefits, these jurisdictions offer corporate vehicles similar to ULCs that may also be treated as fiscally transparent entities for US purposes. As a result, the US-resident investor's tax situation would not be significantly different following the interposition of such foreign intermediary, as both the intermediary and the ULC would be fiscally transparent for US purposes, and the payments made from the ULC would still be subject to a reduced rate as paragraph IV(7)(b) of the Treaty would not apply.
Although simple, this alternative may raise treaty-shopping issues that must be reviewed when considering the implementation of this alternative. Finally, beyond the technical aspects one must also consider the inherent practical realities, including costs, resulting from establishing foreign intermediaries. Indeed, whenever foreign intermediaries come into play, not insignificant sums of money may be required in establishing and maintaining the structure and in assuring the required substance is present in the foreign jurisdiction to make the structure viable from a commercial and tax perspective.
Hybrid instruments may prove to be an interesting alternative to foreign intermediaries. These instruments may take various forms but essentially the intent is to receive equity treatment on one side of the border and debt treatment on the other side. Hybrid instruments have been around for a long time, but they have often played a secondary role to hybrid entity planning as a result of the introduction of the US check-the-box regulations in 1997.
A hybrid financing structure from the US into Canada would generally involve an arrangement between a US entity and a regular Canadian company. To avoid the application of the Treaty's anti-hybrid rules, the Canadian company should be "opaque" for US tax purposes, meaning it should not be treated as a fiscally transparent entity in the US. The instrument would be structured so that it would be a debt for Canadian tax purposes with the result that interest on the debt would be deductible in Canada. However, the instrument would be treated as equity for US tax purposes so that there would not be income recognition in the US on the investment returns.
Key considerations from such a reorganization would include the transition into the structure, and the potential application of the Canadian General Anti-Avoidance Rule. It would also be advisable to obtain Canadian and US opinions on the characterization of the arrangements.
As the above alternatives may not be available to all, it is reassuring to observe that other less complex alternatives may still be available. Again, the Canadian and US tax implications resulting from these alternatives should be considered. These alternatives would include the following:
- US-resident investors could simply "un-check" the box. As a result, the ULC would then lose it's fiscally transparent status in the US. A ULC taxed as a corporation in the US would benefit from the Treaty.
- Rather than using an ULC to carry on its Canadian business, US-resident investors may desire to carry on that business through a branch business in Canada. That could be done through a regular US corporation or through a US partnership or a US LLC. Key consideration would include the application of the rules relating to the attribution of profits to permanent establishments.
- Finally, depending on the circumstances, restructuring the non-arm's length interest payments so they are paid to an affiliate in a third country with a favorable tax treaty with Canada may also be considered.
Without a doubt, US-resident investors into Canada should consider whether they need to reorganize their activities in order to avoid, or at least minimize, the impact of the new anti-hybrid measures included in the Treaty, while taking into consideration the tax consequences of such reorganizations both in Canada and in the US.
US-resident investors are encouraged to contact their Gowlings tax professionals in order to discuss the available options