Article by Kenneth Snider, ©2006, Blake, Cassels & Graydon LLP
This article was originally published in Blakes Bulletin on Cross Border-Tax, March 2006
U.S. tax-exempt organizations considering a potential debt or equity investment in respect of Canadian real estate should focus at an early stage on Canadian tax planning.
The investment may take a variety of forms, including 100% equity ownership, participating as a minority or majority joint venture partner, or a mortgage loan. The transaction will fundamentally affect the planning. Structuring the investment to take advantage of Article XXI of the Canada U.S. Tax Convention (the Convention) will be a fundamental objective. A few preliminary points should be borne in mind. A non-resident of Canada is taxable on income from carrying on business in Canada and on capital gains from the disposition of "taxable Canadian property" under Part I of the Income Tax Act (the Act) subject to the application of a tax treaty. Taxable Canadian property is broadly defined and includes real property situated in Canada; a share of the capital stock of a corporation resident in Canada that is not listed on a prescribed stock exchange; a share that is listed on a prescribed stock exchange if certain ownership tests are satisfied, and interests in certain partnerships and trusts that own taxable Canadian property.
Consequently, if rental income earned by a non-resident was considered income from carrying on a business in Canada it would be taxable under Part I. The Convention, like other of Canada’s tax treaties, does not provide any general relief from tax on income and gains from real estate. In contrast to Part I, certain amounts paid or credited to a non-resident including rent (that is considered income from property and not income from business), dividends and interest are subject to withholding tax at the rate of 25%, subject to possible reduction or exemption under the Convention. There is an election that can be made by the non-resident to be taxed on a net basis in respect of rental income at the applicable rate in Part I instead of being subject to a withholding tax on the gross rent.
Article XXI of the Convention
There are two different exemptions from tax under the Act in Article XXI of relevance to U.S. tax-exempt organizations. First, income derived by a religious, scientific, literary, educational or charitable organization shall be exempt from tax in Canada if it is resident in the U.S. for purposes of the Convention but only to the extent that such income is exempt from U.S. tax. Subject to the qualification discussed below, this exemption will apply to taxes payable under Part I and withholding tax under Part XIII of the Act.
Second, subject to the same qualification discussed below, dividends and interest derived by:
- a trust, company, organization or other arrangement that is a resident of the U.S., generally exempt from U.S. income taxation in a taxable year and operated exclusively to administer or provide pension, retirement or employee benefits; or
- a trust, company, organization or other arrangement that is a resident of the U.S., generally exempt from U.S. income taxation in a taxable year and operated exclusively to earn income for the benefit of an organization referred to in subparagraph (a);
shall be exempt from tax under the Act in that taxable year.
Because the second exemption only applies to interest and dividends subject to Part XIII withholding tax, a U.S. pension does not qualify for any income tax relief in respect of operating income, or recapture and capital gains. Consequently, "substituting" interest (subject to the possible application of the thin capitalization rules in the Act) and dividends for these types of returns from real estate will be important in order to take advantage of the exemption.
An important qualification is that the two exemptions in Article XXI shall not apply with respect to the income (a) from carrying on a trade or business or (b) from a "related person" that is not also an exempt organization as discussed below.
Look Through Approach for Partnerships
Where the recipient of interest or dividends is a partnership of the U.S. pension funds or other entities otherwise qualified for the benefits of Article XXI, CRA has confirmed that it will look through the partnership to each member and grant or withhold the exemption based on the member’s proportionate interest in the partnership.
Related Persons
The restriction in respect of income from a "related person" is very important to consider. The expression is not defined in the Convention for purposes of Article XXI. CRA has considered the meaning of "related person" and whether it has the same meaning as defined under the Act, and whether a similar look-through mentioned above will be applied in determining a member’s "related person" status under Article XXI of the Convention.
CRA has noted that in accordance with the Canadian Income Tax Conventions Interpretation Act, that term has, except to the extent the context otherwise requires, the meaning it has for purposes of the Act. Where a person is a member of a partnership, the CRA will look through to the members in determining whether a particular member is related to the person from which the income is derived and whether Article XXI of the Convention is applied in respect of that member.
As one would expect, the term "related person" is broadly defined in the Act. In summary, the definition turns on a person having legal control of a corporation or the right to acquire control. For instance, a U.S. exempt organization that owned in excess of 50% of the voting shares of a corporation owning Canadian real estate would generally be related to the corporation and would not be entitled to the benefit of Article XXI. There are special considerations in respect of "related persons" and trusts.
Participating Debt
Participating debt should be considered to deal with reducing taxable income of the entity owning the real estate resulting from increased rents (and decreasing capital cost allowance). The "5/25 exemption" restricts the availability of the withholding tax exemption where interest is linked to a variable participation in the borrower’s profits or cash flow. However, the Article XXI exemption should be available in respect of participating interest provided that the payment falls within the definition of "interest" in the Convention. Article XI(4) of the Convention provides as follows:
"The term ‘interest’ as used in this Article means income from debt-claims of every kind, whether or not secured by mortgage, and whether or not carrying a right to participate in the debtor’s profits ... as well as income assimilated to income from money lent by the taxation laws of the Contracting State in which the income arises ..." [Italics added]
With proper crafting of the participating loan instrument, it is possible to design an instrument whose payments qualify both as deductible interest under the Act (subject to the possible application of the thin capitalization rules in the Act) to the payor and interest eligible for the benefits under Article XXI.
Compliance Considerations
The Act imposes a withholding and remittance obligation on the Canadian resident in respect of certain amounts paid or credited to a non-resident regardless of a treaty exemption. As an administrative matter, the Article XXI exemption cannot override the payor’s withholding obligations under Part XIII of the Act. Information Circular IC 77-16R4 authorizes Canadian payors to rely upon the CRA’s published list of treaty exempt investors under Article XXI. In order for the payor to avoid liability for tax, penalties and interest for failure to withhold and remit tax in respect of payments to an organization described in Article XXI(1) and (2), the payor should withhold unless the organization is listed. Tax exempts would also want to avoid being subject to withholding by not being listed and applying for a refund. Paragraph 78 of Information Circular IC 77-16R4 describes the application process for tax exempts to be listed in CRA’s annual publication of exempt U.S. organizations.
With respect to nominees that hold the security, CRA has stated that in the case of a security held in the name of a nominee (including an approved special nominee) for an organization or trust to which a letter of exemption under Article XXI is issued, the Canadian payor is obliged to withhold tax from any payment on the security unless CRA has provided the payor with written authorization to refrain from doing so for payments on the specific security (i.e., name of issuer, serial number, denomination and date of issue of the share or bond certificate) in question. Reference should be made to Information Circular IC 77-16R4 for instructions regarding obtaining authorization.
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.
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