Unless you are very active in Canada-US cross-border tax planning, you probably are not aware of the fact that, a few years ago, the 5th Protocol to the Canada-U.S. Tax Convention (“the Treaty”) created a problem in connection with the ownership of Canadian Unlimited Liability Companies (“ULCs”) by U.S. Residents.

ULCs are a strange feature of corporate law-they are corporations with unlimited liability. At one time, Nova Scotia was the only jurisdiction in Canada that had these entities, and they were modeled after similar entities existing under UK corporate law. However, some years ago Alberta and British Columbia jumped on the ULC bandwagon.

From a Canadian tax perspective, ULCs are taxed in the same way as “normal” Canadian corporations. Their usefulness lies strictly within the context of the arcane world of the U.S. Internal Revenue Code, and the rules that apply to classifying foreign entities. Under the so-called “check the box” rules, Canadian ULCs can be treated as “disregarded entities” (if only one shareholder) or partnerships (if more than one shareholder) for U.S. tax purposes.

This can be useful in many contexts. Most commonly, in cross-border acquisitions it can allow tax credits to be claimed directly in the US for Canadian taxes, as well as the ability to amortize “goodwill” for U.S. tax purposes. In addition, it can allow U.S. citizens or residents the ability to do a tax-free rollover in the U.S. to a Canadian corporation.

The problem was that, under the special rules in the Treaty that deal with “hybrid” entities, dividends paid by a ULC to a U.S. resident would be subject to a 25% Canadian tax under Part XIII of the Income Tax Act (“ITA”) as opposed to 5% or 15%, as before.

Many solutions have been suggested to this problem by this author, as well as others active in this area. They ranged from simple solutions to complex ones involving “treaty shopping” by using a Luxembourg intermediary.

However, the Canada Revenue Agency (“CRA”) has given the green light to a relatively simple and painless solution.

That is, there would be a two-step process to replace what would otherwise be a dividend.

Namely,

(a) Firstly, there would be an increase in the paid-up capital of the ULC shares, by transferring retained earnings to stated capital. This would create a deemed dividend under subsection 84(1) of the ITA, and

(b) Then, the addition stated capital created would be distributed as a reduction in capital to the shareholders of the ULC

The CRA has confirmed that if that process is followed, the deemed dividend would be subject to Canadian tax at the applicable treaty rate (5% or 15%) and the distribution of capital will be non-taxable.

One caveat: this solution will not work if the ULC shares are held through a U.S. LLC.

In accordance with Circular 230 Disclosure