The Fifth Protocol of the Canada-U.S. Tax Convention (the Treaty) introduced new anti-hybrid rules in Article IV(7) intended to deny Treaty benefits for amounts of income, profit or gains involving hybrid entities. The new rules generally operate to deem an amount of income, profit or gain to be not paid to or derived by a resident of a contracting state in certain circumstances. Since the benefits of the Treaty are extended only to residents of the contracting states, the particular amount of income, profit or gain will not have the benefit of any reduced rate of tax that would otherwise be available under the Treaty.

The provinces of Alberta, British Columbia and Nova Scotia allow for the creation of unlimited liability companies (ULCs) under their respective statutes. A ULC is a hybrid entity; it is treated as a corporation for Canadian tax purposes and can be treated as a flow-through or disregarded entity for U.S. tax purposes.

A ULC may be an attractive vehicle for a U.S. investor expanding into Canada for reasons that may include:

• It avoids double taxation in the U.S. as, unlike Canada, the U.S. does not provide full integration between corporate and personal taxation that may arise in corporate structures.
• It allows for losses to flow through to the shareholders to offset a U.S. shareholder's income.
• It allows for investment in passive investments in Canada without triggering U.S. anti-avoidance rules for foreign holding companies.
• It provides flexibility to defer U.S. income tax on the ULC's income (Canadian tax rates are lower than U.S. tax rates) by allowing U.S. shareholders to elect to treat the ULC as a corporation for U.S. income tax purposes so that the ULC income will not be taxed in the U.S. until it is repatriated.
• It has less stringent requirements to have Canadian directors.

Since a ULC is considered an ordinary corporation for Canadian tax purposes, interest, dividends, royalties and other payments from a Canadian ULC to a U.S. shareholder are subject to 25% withholding tax under the Income Tax Act (Canada). The Treaty historically has reduced or eliminated such withholding taxes on many types of payments to U.S. recipients, allowing ULCs to remain tax-efficient for U.S. investors. Under the Treaty, the withholding rates on these types of payments range from 0% to 15%. Effective January 1, 2010, as a result of the ratification of the Fifth Protocol of the Treaty, Treaty-reduced withholding rates on payments by a Canadian ULC to a U.S. recipient are denied where the ULC is treated as a fiscally transparent entity for U.S. tax purposes.

On its own, the denial of treaty benefits on payments of dividends, interest and other payments by ULCs to U.S. investors would make ULCs tax inefficient vehicles for U.S. investors. However, the Canada Revenue Agency has published a series of advance income tax rulings and technical interpretations that accept the use of various repatriation strategies to avoid the application of the new anti-hybrid rule in certain situations. The Canada Revenue Agency accepts these repatriation strategies only in certain circumstances. By way of example, a disregarded U.S. limited liability company (LLC) investing in a ULC can be tax inefficient, and even punitive in some situations, from a Canadian tax perspective.

With careful tax planning in the proper circumstances, and in situations where the benefits of a ULC align with a U.S. investor's tax and business objectives, the ULC remains a useful alternative for structuring investment or expansion by U.S. investors and businesses into Canada.

Maria Severino, CA, is a Tax Partner in the Toronto office of Collins Barrow.