What is a Canadian tax practitioner to do for their clients (or family) who intend to own real property outside of Canada and the US1 ("Foreign Real Property") until death do they part?

Such holdings, while often a source of joy during a Canadian resident's lifetime, can create some serious tax problems for their estate and their heirs. In the discussion that follows, we'll try and illustrate this issue and a possible solution using a fictional client named Maria and a number of hypothetical scenarios.

Facts — Maria's Algarve Property

Imagine that when Maria was 25 years old, she immigrated to Canada from Portugal. Sadly, a number of years later, the last of Maria's parents passed away and left Maria a modest beach home in southern Portugal worth about $100,000 at the time (the "Algarve Property").2

Today, Maria is 60 years old and, to keep the illustration simple, let's assume that her estate is comprised solely of the Algarve Property, now worth $1,100,000, and a debt of $100,000 so that Maria's net estate is worth $1,000,000.

Scenario 1 — Sale of Algarve Property

If Maria were to sell the Algarve Property, both Portugal and Canada would have an opportunity to tax the capital gain of $1,000,000 that will be realized on the sale.3

However, pursuant to Article 13(1) of the Canada-Portugal Tax Treaty,4 the first right to tax capital gains realized on certain immovable property, including real property, is provided to the country where the immovable is located.5 Accordingly, since the Algarve Property is located in Portugal, Portugal would have the first right to tax the capital gains realized on the sale of the Algarve Property.

We understand that the capital gains tax in Portugal would be $280,000, being 28% of the $1,000,000 capital gain, leaving Maria with $720,000 to spend.6

Although Maria will also be taxable in Canada on the Algarve Property capital gain, to minimize incidents of "double taxation", Canada's income tax system has been designed so that, with respect to certain foreign income and gains, such as gains on dispositions of Foreign Real Property, Canada will provide a Canadian taxpayer with a foreign tax credit to offset taxes paid to a foreign government.7 The result of the Canadian foreign tax credit system is that a Canadian taxpayer should only be required to pay tax on income or gains that qualify for a foreign tax credit at the higher of the tax rates of Canada and the foreign jurisdiction.

For convenience, let's assume that the combined effective Canadian federal and provincial tax rate applicable to capital gains realized by Maria in respect of the Algarve Property is 25%. Because the combined Canadian capital gains taxes will be less than the Portuguese capital gains taxes paid (see calculation above), Maria should be eligible to claim a foreign tax credit for the full amount of Portuguese tax paid by her, with the result that no Canadian tax should be payable by her on the Canadian capital gain.

Scenario 2 — Death of Maria Followed by Sale of the Algarve Property

If instead of selling the Algarve Property while she was alive, Maria was to have died and then her estate sold the Algarve Property, very different tax results would have arisen than those set out in Scenario 1.

These different tax results will arise due to the fact that, while Canada deems:

  1. capital property of a decedent to be disposed of immediately prior to death at the FMV of the capital property which will cause unrealized gains and losses to become realized for Canadian income and capital gains tax purposes; and
  2. the estate of a decedent to have acquired the decedent's capital property at its FMV for purposes of determining the ACB of the capital property transmitted to the estate,8

there are no similar deemed disposition rules that apply on the death of an individual in Portugal.

As a result, even though the Canadian capital gains tax was already paid, on a subsequent sale, Portuguese capital gains tax will be payable by Maria's estate or her heirs, as the case may be, since the original cost base of the Algarve Property for Portuguese capital gains tax purposes will not be increased on the death of Maria.

Furthermore, recall that under both the Canada-Portugal Tax Treaty and general international principles,9 Portugal has the first right to tax Portuguese real property, such as the Algarve Property. Therefore, if there is to be a solution to this double tax problem, it would be necessary for Maria's estate or her heirs, as the case may be, to look to the Canadian tax authorities for tax relief. Unfortunately, the Act currently contains no provisions to grant foreign tax credits or any other relief to Maria, her estate, or her heirs for tax paid in Portugal on a subsequent disposition of the Algarve Property.

Having now explained how taxation would apply in this scenario, let's illustrate these principles with Maria's facts in mind, but assume that both at the time of death and at the time of the actual sale of the Algarve Property, its FMV is $1,100,000.

Based on the prior example:

  1. upon Maria's death, it is assumed that a $1,000,000 Canadian capital gain will arise giving rise to combined Canadian taxes of $250,000; and
  2. if Maria's estate or heirs were to sell the Algarve property at some time in the future, a $1,000,000 Portuguese capital gain would be realized, giving rise to Portuguese taxes of $280,000.

As mentioned above, in this scenario, the Act provides no ability for Maria, her estate, or her heirs, as the case may be, to claim a foreign tax credit or any other relief in Canada against Portuguese taxes paid on this subsequent sale. As a result, nearly double the tax is payable in respect of the Algarve Property in this scenario than in Scenario 1. In particular, following the payment of total taxes of $530,000, from her original net FMV estate of $1,000,000, Maria's heirs will only be left with $470,000 compared to the $720,000 they would have inherited if Maria had died after selling the Algarve Property in Scenario 1.

Maria's situation, as described in this scenario, is likely to become a much more common one in the future. This is because many jurisdictions worldwide that have capital gains tax regimes do not tax unrealized capital gains on death, and more and more Canadians than ever before are inheriting or acquiring and dying with Foreign Real Property.

To our knowledge, there is no justification for such an inequitable tax result.

In fact, Parliament acknowledged the inequity in similar situations impacting both emigrating Canadians owning Foreign Real Property and beneficiaries of Canadian resident trusts that receive distributions of Foreign Real Property. As such, it statutorily fixed these inequities by enacting subsections 126(2.21) and 126(2.22), respectively.10 In a nutshell, these two subsections allow a foreign tax credit deductible against tax payable on an individual's departure year Canadian tax return that is equal to the foreign taxes on a post-departure gain from a disposition of property, including Foreign Real Property, to the extent of the portion of the property gain that accrued while the individual was a Canadian resident.

The historical explanatory notes in respect of these provisions state, in part, that:

Subsections 126(2.21) and (2.22) will apply, in most cases, only for taxes paid to countries with which Canada has a tax treaty. Exceptions are provided for taxes imposed by a foreign country on gains on real property situated in that country. In keeping with the general international principle that the country in which real property is located has the first right to tax gains on that real property, Canada will always provide credit for such taxes. Similarly, credit for those taxes will be available regardless whether Canada has a tax treaty with the particular country. (Emphasis added.)

In order to enable subsections 126(2.21) and 126(2.22) to operate outside of ordinary statutory limitation periods, consequential amendments were also made to subsection 152(6).

Scenario 3 — Emigration of Maria Followed by Sale of the Algarve Property

So, coming back to Maria, if she emigrated from Canada while still owning the Algarve Property, she would have been deemed to have disposed of the Algarve Property at its $1,100,000 FMV pursuant to paragraph 128.1(4)(c), giving rise to Canadian deemed capital gains taxes of $250,000.11

Assume that some years following emigration, Maria sold the Algarve Property for $1,100,000. As was the case in Scenario 1 and Scenario 2, Portugal would still collect $280,000 in capital gains taxes. However, provided that Maria amends her emigration year personal Canadian tax return as permitted pursuant to the interaction of subsections 126(2.21) and 152(6), she would be able to claim a tax credit and generate a refund of the $250,000 of taxes she paid upon her emigration, thereby eliminating the otherwise inappropriate double taxation.12

Subsections 126(2.21) and (2.22) Roadmap for a Fix?

It is worth repeating the highlighted portion of the explanatory notes to subsections 126(2.21) and (2.22) above:

In keeping with the general international principle that the country in which real property is located has the first right to tax gains on that real property,Canada will always provide credit for such taxes. (Even more emphasis added.)

As illustrated by the example involving a sale of the Algarve Property in Scenario 2, this general international principle is currently inapplicable in the event of the death of a Canadian taxpayer such as Maria. Consequently, the Department of Finance's statement above (the "Statement of Principle") is untrue in a situation involving the death of a Canadian taxpayer.

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1. The issues described in this article will generally not be a concern in respect of US real property owned by Canadians on death because of unique features of Article XXIX-B in the Fifth Protocol to the Convention Between Canada and the United States of America with Respect to Taxes on Income and on Capital, which coordinate US estate tax and Canadian death taxes with one another and thereby can avoid double taxation issues and allow for US cost base adjustments to match those in Canada, provided the taxpayer in question is an individual and the election under Article XIII(7) is properly filed. Several treaties have similar provisions that coordinate a step-up in tax basis, but they only apply where an individual has ceased residency in a particular country — it is our understanding that none (or almost none) of Canada's other tax treaties contain step-up provisions for deemed disposition on death.

2. Since Maria acquired the beach home by way of a bequest, Maria is deemed under paragraph 69(1)(c) of the Income Tax Act (Canada) (the "Act") for Canadian tax purposes to have acquired the property at an adjusted cost base ("ACB") equal to its fair market value of $100,000 at that time. It is assumed that for Portuguese tax purposes, Maria is considered to have a tax cost base of $100,000 as well.

3. Both Canada and Portugal have capital gains tax regimes. For simplicity, we have assumed both Canadian and Portuguese capital gains will be calculated by netting the current $1,100,000 fair market value ("FMV") of the Algarve Property against its $100,000 ACB.

Our choice of Portugal to illustrate a non-US international jurisdiction in this article is random. All Portuguese tax and legal matters should be reviewed with professionals qualified to practice in those disciplines in Portugal.

4. Convention Between the Government of Canada and the Government of the Portuguese Republic for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, E103231 — CTS 2001 No. 27 ("Canada-Portugal Tax Treaty").

5. Terms similar to Article 13 of the Canada-Portugal Tax Treaty are common in Canada's treaty network for tax treaties that include capital gains tax provisions.

6. Dollar amounts ignore costs of sale, stamp taxes in Portugal, etc.

7. Pursuant to subsection 126(1). The foreign tax credit will not be limited to 15% of the foreign income amount because subsection 20(11) and paragraph (b) of the definition of "non-business-income tax" in subsection 126(7) do not apply to a capital gain.

Please note that, based on general international principles Canadian residents will usually be able to claim a subsection 126(1) foreign tax credit with respect to capital gains tax paid in connection with dispositions of Foreign Real Property regardless of whether the Foreign Real Property is situated in a treaty or a non-treaty jurisdiction (see, for example the views of the Canada Revenue Agency as set out in paragraph 1.62 of Income Tax Folio S5-F2-C1).

8. Pursuant to subsection 70(5).

9. Supra, footnote 5.

10. Bill C-22; S.C. 2001, c. 17, s. 117, applicable to the 1996 and subsequent taxation years.

11. Subject to Maria deferring this tax by posting security acceptable to the Minister of National Revenue and otherwise satisfying the provisions in subsection 220(4.5).

12. As no interest will be refunded to Maria, the time value of money will still negatively impact Maria's financial situation.

Originally Published by Wolters Kluwer

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.