12-Jan-2000
The Nova Scotia Companies Act ('NSCA') permits the incorporation of unlimited liability companies. We understand that the use of such a company to hold the Canadian investments of United States investors may have certain favourable income tax consequences under United States law.
We are not licensed to practise in any of the states of the United States and do not offer any legal advice on matters of US law, however, we set forth our understanding of the reasons why an unlimited liability company ('Unlimco') may be employed for this purpose.
Corporation v. Partnership
We understand that it is attractive for certain US entities to make direct investments in a Canadian 'partnership' rather than a Canadian 'corporation' as classified by the Internal Revenue Service (the 'IRS') and that in certain cases, revenue streams from foreign partnerships will be more favourably taxed than those from foreign corporations.
The structure utilizes an Unlimco, described in greater detail below, as the Canadian investing vehicle. The shareholders of Unlimco would be US entities also qualifying for partnership taxation treatment but with limited liability, such as a limited partnership or a limited liability company (an 'LLC'). While the creditors of Unlimco have no limit on their claim against its shareholders on a winding up of Unlimco, their claims would be limited by interposing a limited partnership or LLC between Unlimco and the ultimate US investor.
However, for Canadian tax or other reasons, it is frequently desirable to have as the Canadian investment vehicle a corporation (rather than a partnership) under Canadian law. A Nova Scotia Unlimco, properly structured, can qualify as a corporation under Canadian law and for Canadian tax purposes but not be classified as a foreign corporation for US tax purposes.
We understand that the IRS will regard a Canadian entity as a 'corporation' if it satisfies any three of the four following criteria. To avoid being categorized as a foreign corporation then, the entity must fail at least two of the four tests:
(a)
The owners of the entity have effectively limited their liability for claims by creditors of the entity to the amount invested in or owing in respect of their ownership interest (the stated capital of the corporation plus any unpaid portion). Such a limitation would normally be found in the incorporating statute and constating documents of the entity;
(b)
Each member, or those members owning substantially all the interests in the organization, has the power, without the consent of other members, to substitute for themselves a person who is not a member of the organization. In a corporate context, the shareholders may sell their shares free of any contractual or generic constraint. A binding contract among shareholders providing for a veto on transfers would be a contractual constraint. A veto provision in the constating documents would be a generic constraint;
(c)
The ownership interests, the group of all members, lack exclusive authority to make management decisions necessary to the conduct of the business of the entity. Management is the responsibility of a board of directors who may delegate day-to-day management to the officers. The corporate management structure is contrasted with the management of a 'partnership' in which the partners collectively are responsible for managing the business; and
(d)
A 'corporation' has a perpetual life, although in many jurisdictions bodies corporate that carry on business may be dissolved by following certain statutory procedures. 'Partnerships' may be dissolved by agreement between the partners or automatically upon the occurrence of certain events (e.g. death of a partner).
Unlimco as a New Company or by Amalgamation
For a startup business, an Unlimco may be incorporated in Nova Scotia and may own property and carry on business anywhere in Canada (or the world for that matter) upon compliance with local law.
Where an existing business is being carried on by a Canadian corporation and it is desired that the characteristics of an Unlimco be adopted, the corporation could be continued into Nova Scotia as an 'ordinary' company with limited liability. The continued company could then amalgamate pursuant to the provisions of the NSCA with a shelf Unlimco and adopt the characteristics of the Unlimco, being its memorandum of association (the 'Memorandum') and articles of association (the 'Articles').
Companies Act (Nova Scotia)
Before addressing specifically the four tests laid down by the IRS, it may be helpful to comment generally on the background and nature of Nova Scotia corporate law.
Nova Scotia corporate law is based both on common law jurisprudence, drawn mainly from England, and on the NSCA. The applicable common law is enriched by the wealth of English jurisprudence dealing with corporate governance. Nova Scotia practice and the courts of Nova Scotia rely substantially on this stable body of jurisprudence to interpret the NSCA, the Memorandum and the Articles which are the constating documents of a Nova Scotia company. The NSCA itself is based essentially on the English Companies (Consolidation) Act, 1908.
The Memorandum is the fundamental document of a Nova Scotia company and is unalterable except as authorized by the NSCA. Conceptually it represents the contractual consensus of all of the shareholders and is binding upon them and future shareholders as well as upon the company and its directors. The Memorandum may provide for:
(a) The objects and powers of the company (and the restriction of same) which may be altered only by special resolution of the shareholders confirmed by court order. The objects and powers may be those of a natural person, in which case an alteration would only be necessary if the company wished in some way to restrict its objects and powers;
(b) For a limited liability company, the capital structure of the company, including the authorized capital and rights and privileges pertaining to each class of shares authorized. An increase in the authorized capital requires only a simple resolution of shareholders and the creation of a new class or series of shares requires a special resolution of shareholders and may be the subject of special approval by an affected existing class or series. No court approval is required. For an Unlimco, these provisions are in the Articles;
(c) Other matters such as those listed below may also be inserted in the Memorandum. Such provisions are unalterable.
The Memorandum is usually short and, except with respect to capital structure for a limited liability company, rarely amended.
The Articles of a Nova Scotia company contain the procedures of corporate governance which are set out in considerable detail. Much of the wording is drawn from comparable English Articles of Association and carries with it the interpretation of a wealth of English jurisprudence.
Subject to the common law principles of good faith and fairness, a company is free to adopt such Articles as it chooses so long as such are not inconsistent with its Memorandum or the provisions of the NSCA.
Failing at Least Two of the Tests
Since the IRS will regard the Canadian entity as a 'corporation' if it satisfies any three of the four tests referred to, to be regarded otherwise, two of the tests must be failed.
1. As with the English Companies Act, both presently and historically, the NSCA permits the incorporation of three types of companies. The most usual is a company limited by shares whereby the ultimate liability of the shareholders is limited on a winding up to the amount unpaid on the shares. Virtually all business companies incorporated under the NSCA are companies limited by shares.
The second type of company is one limited by guarantee, whereby the shareholders' liability is limited to a specific amount. Such companies are rare.
The third type of company is an unlimited liability company whose shareholders remain fully liable to creditors of the company. Creditors must first establish their claim against the company, but if the company cannot respond in payment, they are able to pursue the shareholders by winding up the company and then prosecuting their claim directly against the shareholders. While such companies are relatively unusual in Nova Scotia, they have become popular in England with the requirement since 1967 that all private companies must publicly file their financial statements unless they are or become unlimited liability companies.
While the liability of the shareholders of an unlimited liability company is like that of partners of a partnership, unlimited, there is still a difference in legal status. The unlimited liability company is nonetheless a separate legal entity, whereas a partnership has no separate corporate existence. Partners are directly liable to the creditors of the partnership. The shareholders of an unlimited liability company are liable to contribute to the payment of the debts of the company upon its winding up, but not before.
One consequence of this difference is that an unlimited liability company may enter into contracts containing provisions restricting the liability of its shareholders and stipulating that the funds of the company alone are at risk with respect to the contractual obligations.
2. To qualify a Nova Scotia company as a 'private company' as defined in Canadian securities law, it is routine to insert in the Articles a provision to the effect that a transfer of share ownership cannot be registered by the company unless and until there is an approving resolution of the directors (along with certain other restrictions). The beneficial ownership of shares may, under this provision of the Articles, be transferred between two parties, however, the transferor will remain the registered owner for all purposes, including the payment of dividends or other distributions and the right to vote.
Another well used method of restricting share transfers is by providing in the unanimous shareholders' agreement that no transfer of any interest in the shares may be made without the approval of all of the shareholders. While there is no express statutory recognition of unanimous shareholders' agreements in the NSCA, similar to Section 146 of the Canada Business Corporations Act or Section 108 of the Ontario Business Corporations Act, Nova Scotia corporate law recognizes the efficacy and enforceability of such provisions.
Any such restriction may be placed both in a unanimous shareholders' agreement and in the Articles. If it is desirable to make the provision unalterable, a prohibition against amending the particular Article may be placed in the Memorandum.
3. While Section 102 of the Canada Business Corporations Act and Section 115 of the Ontario Business Corporations Act provide that the directors shall manage the business and affairs of the corporation, subject to any unanimous shareholders' agreement, there is no similar provision in the NSCA (or in the English Companies Act upon which it was based). In Nova Scotia corporate law, as in English corporate law, the shareholders have the right to vest the management of the company as they choose and make provision for this in the Articles. Normally the Articles vest the management of the company in the directors, subject only to those matters which by statute must be determined by the shareholders.
Many businesses in Nova Scotia function essentially as incorporated partnerships. Two or more investors/managers incorporate a company and enter into a unanimous shareholders' agreement providing for arrangements between themselves as owners and for the management of the business. The management provisions usually take the form of a more or less extensive list of business matters that must be agreed to by the shareholders, unanimously or by some special majority, or by their nominee directors.
An appropriately drafted unanimous shareholders' agreement could provide for the manner in which management decisions might be made collectively by the shareholders or a shareholders' committee. As with the transfer provisions, these too could, and should, be reflected in the Articles.
4. A Nova Scotia company may be dissolved either by surrender of its certificate of incorporation pursuant to the NSCA (a 'Voluntary Dissolution') or under the provisions of the Companies Winding Up Act (Nova Scotia) (a 'Winding Up'). In each case, the statute provides for certain criteria to be met and a procedure to be followed leading to a dissolution.
In each case, there is the involvement of a third party. With a Voluntary Dissolution, the Registrar of Joint Stock Companies (Nova Scotia) must be satisfied; with Winding Up, a liquidator must be appointed and a Court must ultimately be satisfied. The reason for involving a third party is to protect the rights of creditors and minority shareholders. This may preclude putting a dissolution on 'automatic pilot' to the extent required by the IRS and may make it more difficult to fail this fourth test.
The information contained in this Client Update is intended for general information only. Please contact any member of our Corporate/Commercial Group in Halifax for additional information:
Stewart McKelvey Stirling Scales
Suite 900, Purdy’s Wharf Tower One
1959 Upper Water Street
P.O. Box 997
Halifax NS B3J 2X2
Telephone: 902.420.3200
Facsimile: 902.420.1417
E-mail Address: smss.com
