The signing of the Fifth Protocol to the Canada-U.S. Tax Treaty (the "Treaty") and the coming into force of the unlimited liability company provisions of the British Columbia Business Corporations Act in October 2007 may affect the manner in which American business enters the Canadian market.
Common U.S. Enterprise Tax Structure
It goes without saying that the pre-eminent consideration for a business entering the Canadian market will be the Canadian and U.S. tax implications to the existing U.S. enterprise. It may not change how it conducts its U.S. business but it may need to set up a new U.S. structure to hold Canadian investments. Business may be conducted in the U.S. using various enterprise forms including LLCs, S-corporations and C-corporations. LLCs and S-corporations can, at the "check-the-box" election of the U.S. entity, be given "see-through" treatment. That is, it can be treated as fiscally transparent for U.S. tax purposes with net income and losses being recognized at the member or shareholder level.
If the U.S. business were to incorporate a typical provincial or federal business corporation in Canada, start-up losses would be trapped in the Canadian subsidiary - an unfavourable result, and one that could be avoided if a fiscally transparent entity for U.S. tax purposes were used.
Treaty benefits are generally available for a U.S. shareholder, however, Canada Revenue Agency ("CRA") has taken the position that a fiscally transparent LLC is not entitled to Treaty benefits. As a result, if a U.S. fiscally transparent LLC were to establish branch plant operations in Canada, it would not be entitled to Treaty benefits and would be subject to a 25% withholding tax on dividends from its Canadian operating subsidiary, and not would be afforded any protection for capital gains under the Treaty.
The Fifth Protocol has been signed but not yet enacted by either Canada or the U.S. It is hoped that enactments will be in place by January 1, 2008, although this seems highly optimistic.
Various provisions of the Treaty have different effective dates. Immediately upon the Fifth Protocol being enacted, for an LLC conducting business in Canada, any amount of income, profit or gain will be considered to have been earned by each U.S. resident who is a member of the LLC, provided the U.S. tax treatment is the same as its treatment would be if the income, profit or gain had been derived directly by that person. In addition, U.S. members of a Canadian unlimited liability corporation (a "ULC") will not enjoy benefits under the Treaty in respect of income, profit or gain derived through a ULC with effect from and after the third anniversary of the date on which the Fifth Protocol comes into force.
The Fifth Protocol introduces a "limitation of benefits" concept which will deny Treaty benefits unless the U.S. person, for example, U.S. member of the LLC, satisfies certain tests. Obviously, as the Fifth Protocol is enacted, existing structures and the effect on new transactions must be examined. There are numerous planning alternatives that will avoid the loss of Treaty benefits.
Commonly Used Structure Involving a ULC Incorporated in Canada
This summary is not intended to describe the more exotic of cross-border structures that have been used by U.S. enterprises entering the Canadian market. However, prior to signing of the Fifth Protocol, a U.S. enterprise would commonly establish business in Canada by incorporating a ULC. A ULC is recognized in Canada as a corporation for all purposes, albeit one where the shareholders are liable for the third party obligations of the ULC to the extent provided for in the incorporating Act. A ULC, having been incorporated in Canada, is resident in Canada for tax purposes; it pays tax in Canada, and it would withhold and remit to CRA a tax of 5% on dividends paid to its U.S. corporate parent. The ULCs shareholder would "check the box" under U.S. tax law to have the ULC treated as a fiscally transparent entity for U.S. tax purposes. The U.S. shareholder would file its U.S. tax return including the income and expenses of the ULC as its own, and, subject to restrictions, under U.S. tax law claim a foreign tax credit or deduction equal to the taxes paid in Canada, including the 5% withholding tax on dividends paid to it.
Various Provinces Offer ULCs
Until last year, only the Nova Scotia Companies Act provided for the incorporation of ULCs. Last year, the Alberta Business Corporations Act was amended to provide for the incorporation of ULCs. Finally, in late October 2007, the amendments to the British Columbia Business Corporations Act came into effect, resulting in a third jurisdiction in Canada under which a ULC may be incorporated. For the purposes of this discussion, the key differences between the three alternatives are:
- neither Nova Scotia nor B.C. require that any of the directors of the ULC be resident Canadians;
- both Alberta and B.C. provide for electronic filing of articles the Nova Scotia is not a modern corporate statute;
- neither Alberta nor B.C. has annual filing fees and the incorporation filing fees are comparable to those for business corporations (i.e. less than $500) in contrast,
- Nova Scotia incorporation and annual filing fees are significant ($1,000 and $2,750, respectively); and
- the liability of shareholders for ULC creditor claims is immediate for both Alberta and the Nova Scotia ULCs, but only applies to the deficiency (if any) on wind-up for B.C. ULCs.
Extra-Provincial Licensing Considerations
Generally, each Canadian province requires any corporation not incorporated in the province that has a place of business in the province or employees reporting to work in the province to apply for and have issued to it an extra-provincial licence. The application requires that a computerized search report (a NUANS report) be submitted with the application. The search is conducted against a government approved database of the names of enterprises conducting business in Canada and the report must disclose that there is no conflict between the name of the applicant and the name of another enterprise already conducting business in the province. If there is a name conflict that is not acceptable to the public servant mandated with supervision of the issue of extra-provincial licences, the licence may contain a restriction as to the name that the applicant may use in the province.
Ontario is the only province in Canada that permits any corporation incorporated under the Canada Business Corporations Act or any provincial or territorial Business Corporations Act to conduct business in Ontario without an extra-provincial licence. No NUANS search is required. The only requirement is that the corporation file a notice form under the Ontario Corporations Information Act. As a result, there are no significant additional costs for entering the Ontario market using, say, a B.C. ULC than would be incurred by opening a branch plant in Ontario and applying for an extra-provincial licence in Ontario.
Branch Plant Alternative
The U.S. entity can enter Canada by applying for, and obtaining, an extra-provincial licence in its own name (subject to the comments above) for each of the provinces in which it conducts business (has a location in or an employee reporting for work in the province in question) a "branch plant" approach. The foregoing may involve several extra-provincial licences. In each such province, the entity will have to appoint an agent for service of legal papers. Generally, the legal firm acting in obtaining the licence will agree to act as agent for service. The issue of Canadian resident directors obviously does not arise under a branch plant arrangement.
The income earned by the U.S. entity from its Canadian branch plant operations is generally taxable in Canada. The U.S. entity has to prepare and file federal and provincial tax returns on an unconsolidated basis. To the extent that profits from the Canadian operations do not remain in Canada, the U.S. entity must pay a branch plant tax of 5% on such profits, subject to a cumulative $500,000 branch plant profit exemption from the said tax pursuant to the Treaty.
Any person paying a fee, commission or other amount in respect of services rendered in Canada by a non-resident must deduct and remit to CRA 15% of the amount unless a waiver was obtained from CRA. Each year, the U.S. entity would file a tax return disclosing the tax paid on its behalf. The amount remitted is only an estimate, and any overpayment of tax would be refunded following the filing of a tax return.
The sale of the branch plant assets will generally attract tax under the Income Tax Act (Canada) without any Treaty protection. In contrast, the sale of the shares of a ULC or other Canadian incorporated corporation would not generally attract capital gains tax provided the gain realized by the U.S. shareholder was Treaty protected.
Based on the foregoing, until the Treaty is amended by the Fifth Protocol, it is highly unlikely that an LLC would wish to establish a branch plant operation in Canada because it would not be entitled to Treaty benefits. However, once the Fifth Protocol comes into effect, a fiscally transparent LLC may be a suitable vehicle to carry on a branch plant operation in Canada from a tax perspective, depending on the particular circumstances. At this point in time, it is not clear whether the LLC or its U.S. members will have the Canadian tax compliance obligation.
Finally, if an LLC were to attempt to register to conduct business in Canada, it might be surprised at the inconsistent approaches taken on Canadian provinces. Most of the provinces treat an LLC as an extra-provincial corporation requiring the usual licence. In contrast, Ontario requires the bare minimum, that is, that the LLC file a business name registration under the Business Names Act. It may be that Ontario treats the members as conducting business in Ontario, and that might lead to a request that each member of the LLC apply for an extra-provincial licence. Alberta adopts the other extreme; it will only issue an extra-provincial licence to an LLC against receipt of opinions from an attorney in the LLC constituting jurisdiction and a lawyer qualified to practice in Alberta.