Article by Bill Maclagan, Blake, Cassels & Graydon LLP
This article was originally published in Blakes Bulletin on Cross-Border Taxation - November 2004
In Canada, dividends, interest, royalties and certain other payments paid to non-residents are subject to 25% withholding tax on the gross amount pursuant to the Income Tax Act (Canada) (the Act). Under most of Canada’s tax treaties, including the Canada-U.S. Tax Convention (the US Treaty) and the Canada-U.K. Tax Convention (the UK Treaty), the withholding rate is reduced on payments to persons who are residents of the U. S. or the U.K., respectively for purposes of the US Treaty or the UK Treaty. Under the US Treaty, the withholding tax rate for interest is 10% and for dividends is 15%. If the dividends are paid to a U.S. resident company that owns 10% or more of the voting stock of the payor, and is the beneficial owner of such dividends, the rate is reduced to 5%. Generally, when withholding, Canadian residents will withhold based on treaty rates if proof of residency is provided. The resident, however, could, if being cautious, withhold 25% as required under the Act unless the non-resident produces a waiver signed by an official of the Canada Revenue Agency (CRA).
In determining if reduced treaty rates apply, the CRA looks through the partnership to determine residency for tax purposes. For example, in the case of a partnership that has one partner resident in the U.S. and one resident in a non-treaty jurisdiction, the reduced withholding applies to the portion that is notionally earned by the U.S. resident.
Canada can be somewhat inconsistent in its treatment of partnerships for tax purposes. This is especially the case in providing treaty benefits to partners of a partnership in situations relating to the earning of income from property such as dividends or interest and the taxation of capital gains. For the most part, relief is provided, but it can require the provision of a substantial amount of information to the CRA to obtain relief.
Generally under Canadian tax law, a partnership is not treated as a person. The income, including capital gains, earned by the partnership is calculated at the partnership level, is allocated to the partners and is taxed in their hands generally in the same manner as if earned directly by the partners. In the case of payments subject to withholding tax, however, a payment to a partnership with even one non-resident partner is treated as a payment to a non-resident person. The entire payment is subject to withholding tax. Resident partners can then claim the remitted withholding tax as a payment against their tax payable.
If the non-resident is resident in a jurisdiction with which Canada has a tax treaty, Canada will permit the non-resident to claim the lower treaty tax rate. Thus, on interest paid to a U.S. resident, the 10% rate will be applied, and on dividends, a 15% rate will apply. If the resident payor has withheld 25%, the non-resident will be required to file proof of residency and claim a refund for the excess withholding. The CRA will not, however, apply the 5% treaty rate on dividends paid to a partnership even if some or all of the partners are U.S. resident companies. This is on the basis that the partner, while being taxed on the dividends, does not own an interest in the underlying shares, and so cannot meet the 10% ownership test. Thus, the additional reduction is not applicable. This is a somewhat odd interpretation given how CRA applies the treaty benefits in the case of capital gains.
Under the Act, non-residents are subject to tax on capital gains realized on the disposition of "taxable Canadian property" (TCP). TCP includes, amongst other things, shares in Canadian companies and direct, and certain indirect, interests in real property. In most cases, a non-resident disposing of TCP must provide a clearance certificate to a purchaser of the TCP or the purchaser must withhold 25% of purchase price (Section 116 Clearance Certificate). Under many Canadian tax treaties, non-residents are not subject to tax on capital gains, unless the gain is from the sale of real property or a share (or interest) in a corporation, partnership or trust that is resident in Canada and derives its fair market value principally from real property located in Canada. This is the situation under the US Treaty.
In analysing the taxation of capital gains realised by a partnership and treaty benefits, CRA will take the position that each partner is disposing of a percentage interest in the property generally corresponding to its percentage interest in the partnership. This appears to be the opposite of the position taken with respect to dividends, but in this case is very beneficial.
Where TCP is disposed of by a partnership, the partnership is required to obtain Section 116 Clearance Certificates for each of its non-resident partners. Generally, the partnership can file for one clearance certificate disclosing the adjusted cost base, purchase price and gain and withholding amount required in respect of each non-resident. If the non-resident partner is resident in a treaty country and evidence of this is proved to the satisfaction of the CRA, the CRA will generally grant treaty protection and waive withholding at the Section 116 Clearance Certificate stage. At that stage, CRA will require proof of residency status of the partners to grant treaty protection. This proof may take the form of a certificate of residency issued by a local tax jurisdiction and a tax return showing residency and that the partner is subject to tax in the home jurisdiction. If the CRA is not satisfied with the proof of residency, however, CRA will require the 25% withholding to be remitted on account of the non-resident’s potential tax liability, and the partner will have to file a Canadian tax return and claim a refund of the withheld amount.
Attempting to comply with CRA requirements to obtain treaty protection can be very difficult in the case of partnerships with a large number of non-resident partners resident in a number of different jurisdictions. Often the partners do not want to disclose information, the investment is small for each partner and it is difficult to get the partners to focus on the issue and provide the information, or the partnership agreement may prohibit making an investment in a foreign country if the partners could be required to file a tax return in that country. This problem can sometimes be alleviated by prior planning and holding the Canadian assets through a foreign company that obtains treaty protection in Canada and is subject to low rates of tax in the treaty jurisdiction.
It is also important to note that partners entitled to any portion of the proceeds must file a Canadian tax return in any year that a partnership disposes of TCP. This is the case even if treaty protection is claimed.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.