Unlimited Liability Corporations (“ULCs”) and other flow through entities – The new Fifth Protocol to the Canada-United States Income Tax Convention

In the recent past, US taxpayers who wanted to invest in Canada would often do so with structures that would avoid inefficient tax results on both sides of the border.  One of the common structures that was employed in the corporate context was to utilize certain Canadian corporations that were fiscally transparent for US purposes.  In Canada, such corporations only existed in Nova Scotia (as a Nova Scotia Unlimited Liability Corporation) or in Alberta (as an Alberta Unlimited Liability Corporation).  To the extent that a US taxpayer owned, say 100% of the shares of the ULC, all of the profits of the ULC would generally be fiscally transparent for US tax purposes (meaning that the US would not respect the ULC as being a separate legal entity and would require the profits of the ULC to be included in the US taxpayer’s income directly). For Canadian purposes, the ULC was treated as a “normal” corporation for taxation purposes and thus the profits were subject to Canadian tax with such tax generally being creditable against the US tax on the ULC’s profits.  The result was the avoidance of potential inefficient tax results on an overall basis.  To the extent that the profits of the ULC were repatriated to the US parent by way of a dividend, such dividends would often be subject to “treaty benefits” which would result in a reduced withholding tax rate.

Conversely, a Canadian taxpayer who wished to invest in the US would often utilize a US Limited Liability Corporation (“LLC”) for reasons that are similar to the above but are beyond the scope of this blog entry.

On December 15, 2008, the Fifth Protocol to the Canada-United States Income Tax Convention came into force.  A large surprise with the new Protocol was how ULCs and other fiscally transparent entities such as US LLCs (or sometimes partnerships) were to be treated.  New paragraph 7 of Article 4 of the revised treaty contains provisions that essentially deny treaty benefits to such fiscally transparent entities in many cases. However, the impact and implementation of the new provisions was delayed until January 1, 2010.  Accordingly, taxpayers and their advisors now have roughly four months to deal with the pending impact of the new provisions.  Taxpayers who are impacted by such a change should consider alternative structures that would avoid the negative consequences of the new rules.

Moodys LLP Tax Advisors’ professionals would be pleased to discuss recommendations to the extent that you are impacted by these new provisions.