Formation of an NSULC

An NSULC is incorporated pursuant to the Nova Scotia Companies Act. A memorandum of association, a solicitor’s declaration and a list of officers and directors must be filed with the Registrar of Joint Stock Companies. The memorandum of association records the name of the company, any restrictions on its objects and details regarding share capital. The amount of share capital must be specified. There is no restriction on the number of shareholders. A shareholder must be a legal entity.

The corporation must maintain a registered office in Nova Scotia and have a registered agent for service in Nova Scotia. There is a requirement for an annual corporate statement to be filed and a fee of $85 to be paid. There is no requirement for Canadian directors.

Tax Treatment

In Canada, an NSULC is considered to be a corporation under the Income Tax Act and, therefore, an NSULC is treated like any other Canadian corporation for Canadian tax purposes.

In the U.S., an NSULC is not treated as a corporation under the Internal Revenue Code. Any business entity that is not required to be treated as a corporation is eligible, under the “check the box” rules, to choose its classification for U.S. federal tax purposes. Therefore, an NSULC is eligible to choose a classification that allows for flow-through treatment of corporate income to the shareholders and it would be taxed in their personal hands. Any Canadian taxes paid by an NSULC would be considered to have been paid by its shareholders for U.S. tax purposes and the Canadian taxes would, therefore, be eligible for U.S. foreign tax credit claims. Any losses realized by an NSULC would be considered to have been realized by its shareholders for U.S. federal tax purposes.

An NSULC controlled by non-residents of Canada will not be eligible for the small business deduction or refundable dividend tax on hand and will pay tax at a rate of approximately 44%. An NSULC will be subject to provincial tax in the provinces in which it has a permanent establishment or employees. Canadian corporate taxes will be available to U.S. shareholders as a foreign tax credit, within prescribed limits, against U.S. taxes.

Certain U.S. states still rely on the “four factors” test and this may require the alteration of Standard Memorandum and Articles of Association for an NSULC in order to obtain flow-through treatment for tax purposes in those states.

Under the Canada-U.S. Tax Treaty, an NSULC is a “company” for Canadian purposes of applying the treaty and is a “resident” of Canada under Article IV of the treaty. Therefore, unlike a U.S. limited liability company, an NSULC benefits from the treaty. A subsequent sale of an NSULC by a U.S. shareholder is treaty exempt unless the shares derive their value primarily from Canadian real estate.

A U.S. Corporation owning an NSULC would be able to deduct losses against its U.S. profits (subject to the U.S. dual consolidated-loss rules) without suffering branch tax in Canada. A U.S. corporate shareholder that owns more than 10% of the shares of the NSULC can benefit from the reduced 5% dividend withholding rate under the treaty. A U.S. S Corporation can acquire shares of an NSULC, although it cannot acquire the shares of an ordinary Canadian corporation. Interposing a U.S. S Corporation or limited partnership between U.S. shareholders and an NSULC will protect them from the joint and several liability obligations of NSULC shareholders.

Tax Planning Strategies

Acquisition of a Canadian Rental Property

U.S. residents who wish to purchase Canadian rental property may find that using an NSULC is a tax effective strategy.

An NSULC will be a Canadian resident and, therefore, rent payments made to an NSULC will not be subject to the 25% withholding requirements imposed by the Canadian Income Tax Act. Under the Act, a Canadian resident who pays rent to a non-resident must withhold tax from the rent payment at a rate of 25%. Although it is possible for the withholding to be based on the net rent instead of the gross rent (providing that the non-resident arranges for a Canadian agent to collect the rent and to remit the withholding tax), there would still be Canadian tax filing requirements in respect of the rental activity.

In many cases, taxable income is not expected for several years with a rental property, due to various costs such as interest. U.S. shareholders of an NSULC would benefit from this as they would be able to deduct their proportionate share of the losses in calculating their taxable income in the U.S.

When the NSULC has taxable income, it will be subject to Canadian tax at a rate of approximately 44%. A foreign tax credit will be available to U.S. shareholders of the NSULC.

Purchase of a Canadian Business

U.S. residents or corporations who are interested in buying the assets of a Canadian business from Canadian shareholders, who want to sell their shares in order to access the $500,000 capital gains exemption, should consider using an NSULC.

If the company (Targetco) were an Ontario company, it could be converted into an NSULC and the Canadian shareholder could treat the sale as a sale of shares and the U.S. purchaser could treat the sale as a purchase of assets. The Ontario company would be continued in Nova Scotia as an ordinary Nova Scotia company. This would require the consent of the Ontario Minister of Finance (this takes about a week) and authorization under the Ontario Business Corporations Act, supported by a special shareholders’ resolution (this takes a day or two). An NSULC (Purchaseco) would then be incorporated by the U.S. resident and used to purchase the shares of Targetco. Purchaseco and Targetco would then be amalgamated to continue as an NSULC (Amalgco). The amalgamation would require the approval of a Nova Scotia Supreme Court Judge in Chambers and the approval of major creditors with an affidavit that trade creditors would be paid in the ordinary course of business (this takes about two weeks). The U.S. shareholders of Amalgco would then benefit from flow-through treatment of the income or losses of Amalgco.

Another option would be to use two NSULC’s in order to allow the U.S. purchaser to deduct purchase price interest. First, Targetco would be continued in Nova Scotia as an ordinary Nova Scotia company. Then the owners of Targetco would incorporate an NSULC and Targetco and the NSULC would be amalgamated to continue as an NSULC (Amalgco). The U.S. purchaser would then incorporate an NSULC (Purchaseco) which could be owned by a U.S. S Corporation. Purchaseco would be financed so that the acquisition of Amalgco is structured as 25% equity and 75% interest-bearing debt of Purchaseco to avoid the thin capitalization rules. Purchaseco would then purchase the shares of Amalgco and Purchaseco and Amalgco would then be amalgamated to continue as an NSULC. The interest on the debt could be deducted in calculating the Canadian taxable income of the target business. The purchaser would have a stepped-up basis in the assets for U.S. tax purposes since the target company is treated as a flow-through entity.

Conclusion

An NSULC can be an effective strategy for U.S. residents who desire to hold investments in Canada. In some situations, the use of an NSULC would not be tax effective and may, in fact, be detrimental.

Due to the general nature of the bulletin, it should not be relied upon as legal or tax advice.