Article by Kenneth Snider, Blake, Cassels & Graydon LLP
This article was originally published in Blakes Bulletin on Cross Border Taxation - November 2004
A U.S. taxpayer (UST) making an investment in Canadian real estate is faced with the decision of direct ownership (or through a U.S. entity) or interposing a Canadian entity. Direct ownership can, in some instances, provide certain Canadian tax advantages as outlined below, compared to using a Canadian corporation.
Payments by U.S. Taxpayers to Other Non-Residents of Canada
There is a fundamental difference in the Canadian tax treatment of a non-resident depending on whether the income is from carrying on a business or is income from property (that is not business income). First, subject to the Canada-U.S. Tax Convention (US Treaty), a UST that carries on business in Canada for Canadian tax purposes will be subject to tax under the Income Tax Act (Canada) (Act) and will be entitled to claim deductions in computing its Canadian income in the same manner as a resident. Second, a UST earning rental income from real estate which does not constitute carrying on a business is subject to withholding tax at the rate of 25% on the gross amount of the rent unless the UST elects to pay tax on a net basis and files a Canadian tax return (Net Basis Election). In this case, the UST will be entitled to claim certain deductions in computing income such as interest on a loan to acquire the property.
The first benefit of direct ownership by a non-resident of a Canadian business or real estate is that the thin capitalization rules that can restrict interest deductibility are only applicable to corporations resident in Canada. Therefore, Canadian taxes may possibly be reduced through increased related party debt. The second potential benefit, in circumstances described below, is avoiding Canadian withholding tax. Amounts paid by one non-resident to another non-resident will generally not be subject to Canadian withholding tax subject to rules which may deem the non-resident payor to be a resident of Canada for withholding tax purposes in respect of amounts deducted in computing income (e.g., interest) that are paid to other non-residents of Canada (Other Non-Resident). If the amounts are paid by the UST to a non-resident of the U.S., the U.S. withholding tax implications should be considered.
There are two relevant provisions in the Act which can impose withholding tax on certain amounts paid by a non-resident of Canada. The first provides that where a non-resident person pays, among other things, interest on any mortgage secured by real property situated in Canada, to the extent the amount paid is deductible in computing either (i) "taxable income earned in Canada" (i.e., it is carrying on business in Canada), or (ii) the amount on which it is liable under Part I (i.e., it makes a Net Basis Election), the non-resident is deemed to be a resident of Canada. Consequently, if such non-resident pays interest on a mortgage secured by Canadian real property and deducts it, there will be withholding tax at the rate of 25% subject to the provisions of a tax convention between Canada and the country in which the Other Non-Resident resides. The relevant convention may reduce or possibly eliminate Canadian withholding tax.
The second provision, based on proposed amendments, is much broader in some respects than the first provision. It provides, in effect, that when a particular non-resident person pays or credits to another non-resident person an amount except an amount to which the first provision applies, that person is deemed to be a person resident in Canada in respect of the portion of the amount that is deductible in computing its "taxable income earned in Canada" for any taxation year from sources subject to certain exclusions.
This provision as amended would not apply if the deduction of the interest is under a Net Basis Election. We understand that the Department of Finance agrees with this conclusion. This provides an important planning opportunity for non-resident real estate ownership that generates property income and not business income provided the loan does not have to be secured by a mortgage on real estate in Canada. A two-tier structure can be used to avoid withholding tax on interest under either provision. If a UST loans funds not secured by a mortgage on Canadian real estate to a related UST which acquires the Canadian real estate (which does not constitute a business), the latter will deduct the interest under the Net Basis Election, but the interest will not be subject to Canadian withholding tax. In addition, because the thin capitalization rules will not apply, an increased amount of interest may be deductible. This may result in significant Canadian tax savings.
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.
