Lenders: Be Mindful When Taking a Pledge of Shares in a ULC
In Canada, the Nova Scotia Companies Act, the Alberta Business Corporations Act, and the British Columbia Business Corporations Act provide for the formation of unlimited liability corporations (“ULCs”). Although a corporation for Canadian income tax purposes, a ULC may elect to be treated instead as a flow-through entity for U.S. income tax purposes. For this reason, ULCs have been used frequently by U.S. taxpayers for investments in Canada as well as by Canadian taxpayers in U.S. transactions.
As the name suggests, both past (especially under the Alberta statute) and present shareholders of a ULC may become liable for the obligations and liabilities of the ULC: under the Nova Scotia and British Columbia statutes, to the extent of any shortfall in assets versus liabilities upon the winding up the ULC; and under the Alberta statute, jointly and severally with the ULC even before dissolution. There is a risk that a secured lender taking a pledge of ULC shares may inadvertently become (or be legally deemed to have become) a shareholder of the ULC, thereby exposing the lender to liability for the liabilities of the ULC. The more the rights obtained by the lender with respect to the ULC shares resemble rights normally associated with ownership, the more significant the risk.
Accordingly, it is prudent to restrict in the relevant pledge agreement the lender’s rights with respect to management and control of the ULC before demand and realization. Lenders often attempt to accomplish this by including a provision to the effect that any such rights are disclaimed, together with a proviso that the lender may determine, at the appropriate time, the extent to which it actually wishes to exercise the remedies otherwise available to it. While this may be satisfactory in theory, as a practical matter the lender must ensure that it does not, as a matter of fact, obtain (or be deemed to have obtained) a beneficial interest in the ULC share collateral. Besides the obvious (e.g. not becoming or applying to become registered as a shareholder or member of a ULC, not requesting or agreeing to a notation being entered in its favour in the share register of a ULC, and not obtaining, exercising, or attempting to exercise any rights of a shareholder or member of a ULC), this might also include (in the case of a ULC with private company restrictions in its organizational documents) not having the directors of the ULC provide any required share transfer consent in advance.
Incidentally - and, significantly from a secured creditor’s perspective – a ULC would not appear to be a “foreign subsidiary” for purposes of 956 of the U.S. tax code. A US corporate parent should therefore be able to pledge a 100% ownership interest in a Canadian subsidiary which is a ULC without resulting adverse tax consequences.
Please note that the historical cross-border tax arbitrage advantage afforded by ULCs has now been moderated by new tax rules (potentially resulting in higher rates of withholding tax) which came into effect on January 1, 2010. More information on the new rules is provided on our website here and here.
