Publications
Inbound Investment into Canada
by Marco Dolfi
September, 2004
Limited liability companies ("LLC") have become popular business structures for many investors operating in the United States. One of the principal benefits of operating through an LLC is that an LLC may avoid entity-level tax by having its income taxed in the hands of its members. In light of the popularity of LLCs in the U.S., many investors considering inbound investment into Canada assume that they can use an LLC to make their foreign investment. Unfortunately this assumption may lead to unforeseen tax consequences for the uninformed investor.
Taxation of Non-Residents in Canada
Under the Income Tax Act (Canada), non-residents (including non-resident corporations) are subject to tax on any income derived from carrying on business in Canada. In many instances, The Canada-U.S. Income Tax Treaty of 1980 (the "Treaty") will provide relief to residents of Canada or the U.S. from double taxation. In order to qualify under the Treaty, the investor must be a "resident of a contracting state".
An LLC whose income is taxed in the hands of its members is not considered a "resident" for purposes of the Treaty, and therefore could be exposed to double taxation. In addition, the LLC may not qualify for various other benefits available under the Treaty such as special Treaty rates in respect of branch taxes, dividends, and capital gains.
Alternative Business Structures
Fortunately, there are a number of alternative business structures which U.S. investors can use to make their inbound investment. In our experience, the most commonly used business structures for inbound investment are the use of a "branch" of a U.S. company and the use of a Nova Scotia unlimited company.
A. Canadian Branch Structure
Using a Canadian branch of a U.S. company is the most simplistic and least expensive option. This structure requires that the U.S. investor have an existing corporation formed in the U.S., which it will use to operate business in Canada. In order to qualify under the Treaty, the U.S. parent company should not be an LLC. As a branch of the U.S. parent company, profits and losses of the branch are realized or incurred directly by the U.S. company and can generally be applied against other income or losses of the parent company and its affiliates in the U.S.
Before a foreign corporation can commence business operations in Canada through a branch, it will be required to obtain an extra-provincial license authorizing it to conduct business in each Province in which the branch intends to operate.
B. Nova Scotia Unlimited Liability Company
The Companies Act (Nova Scotia) permits the incorporation of an unlimited liability company ("ULC"), which is a unique business entity. This is the only business structure in Canada which most closely resembles the attributes of an LLC.
If structured properly, the ULC would be taxed in Canada as a regular Canadian corporation, but for U.S. tax purposes, its income would "flow through" to the U.S. shareholders of the ULC in a similar manner as if the shareholders were members of an LLC.
Unlike members of an LLC, the shareholders of a ULC are jointly and severally liable for all of the ULC's debts and other liabilities on the bankruptcy or winding up of the ULC. In order to limit this liability we typically recommend interposing a "shell" entity such as a "S" corporation (which in turn allows for a flow-through to its shareholders) between the ULC and the U.S. investors whose assets would otherwise be exposed.
Conclusions
U.S. investors considering commencing business operations in Canada should consider their options with respect to business structures carefully, and in most cases, should avoid the use of LLCs for their inbound investment.
Article submitted by Marco Dolfi. Mr. Dolfi is a partner with Ducharme Fox LLP, a law firm in Windsor, Ontario. Berry Moorman and Ducharme Fox LLP have advised mutual cross-border clients in the implementation of effective business plans developed to suit the clients' operations in Canada and the U.S. For further information, please contact Randolph M. Wright at Berry Moorman.