Canadian company formed by U.S. S corporation will be considered a partnership.

The IRS recently approved a format for doing business in Canada that allows a U.S. company to claim Canadian losses on its U.S. return. Further, if this format is used in a joint venture format with a Canadian local company, it permits maximum use of foreign tax credits. The facts of recently issued Letter Ruling 9538020 are as follows:

[] X was incorporated in 1962 and elected S status in 1987.

[] Y was incorporated in 1994 and immediately elected S status.

[] X and Y have identical ownership.

[] On Nov. 1, 1994, X and Y formed Z as a company of unlimited liability under the Nova Scotia Companies Act.

[] X owed 79% of Z and Y owned the remaining 21

[] Y planned to transfer a portion of its interest in Z to X so that X would own more than 80% of Z, but that Y would at all times own at least 1% of Z The before/after ownership structure is depicted in the chart on page 74.

In reviewing Z's status for U.S. Federal income tax purposes, the Service reviewed the Nova Scotia Companies Act, particularly as to continuity of life, centralization of management, limited liability, and the free transferability of interests.

In terms of liability, the IRS noted that under Section 135 of the Nova Scotia Companies Act, during a windup, the members of an unlimited company were liable to contribute to the company's assets an amount sufficient for the payment of its liabilities together with the expense of winding up.

Z's memorandum of association stated that Z was an unlimited liability company; therefore, Z's members were liable to contribute an unlimited amount to pay Z's liability when Z was wound up. Thus, Z did not have limited liability.

In terms of free transferability of interests, the Service noted that Section 32 of the Nova Scotia Companies Act provided that the ownership interest of any member in a company is transferable in the manner provided by the company's articles. Z's articles of association specifically prohibited any transfer of ownership interest in the company without the prior written consent of all the owners. Further, Z's owners were only allowed to transfer their ownership interest in Z to other Z owners or to Z itself. Moreover, the articles stated that Z was a private company and noted the only permitted transfers. Based on the foregoing, the IRS concluded that Z lacked free transferability.

Accordingly, since Z lacked both limited liability and free transferability, Z did not have more corporate than noncorporate characteristics and therefore was classified as a partnership for Federal income tax purposes.

This ruling is the first to address the U.S. tax status of a Nova Scotia unlimited liability company, and thus is important to all U.S. commercial investors with commercial investments in Canada. However, it should be noted that, despite the treatment accorded this entity for U.S. tax purposes, such is not the case with respect to Canadian taxation.

In Canada, a Canadian corporation is subject to tax, and shareholders are in turn taxed on after-tax dividends (albeit with relief in the form of an integrated Canadian tax credit). In the cross-border situation in which shareholders such as X and Y in the ruling own shares of a Nova Scotia unlimited liability company, despite the U.S. tax treatment Z will continue to be taxed as a corporation for Canadian corporate income tax purposes. Furthermore, withholding taxes applicable under the U.S. Canadian income tax treaty will continue to apply. This is an important issue. Many U.S. taxpayers have held the mistaken belief that a fiscal transparency in the U.S. vis-a-vis a Nova Scotia unlimited liability company results in the same treatment in Canada. Such is not the case and should be borne in mind whenever crossing the U.S.-Canadian border.