Ownership Structures for Non-Canadian Investors in Canadian Real Estate

This article was originally published in Blakes Bulletin on Cross-Border Tax, March 2006

A non-Canadian investor’s after tax return from an investment in Canadian real estate will depend vitally on the legal structure through which the real estate is acquired and held. This article summarizes some of the tax considerations arising with alternative structures.

The appropriate structure will vary from case to case depending upon several factors, including:

• Status of the non-Canadian investor. In particular, some U.S. tax exempt entities can benefit from specific exemptions in the Canada-U.S. Tax Treaty. Different considerations arise for investors that are organized as limited liability companies (LLCs), and for taxable investors.
• Nature of the real property investment. The Canadian tax system draws a fundamental distinction between assets held as long-term investments (i.e., capital assets) and trading assets. A lower capital gains rate applies to dispositions of capital assets. Also, an important distinction is drawn between "business income" and "property income".
• Province in which the real property is located. In recent years, the disparity in provincial tax rates has grown, as some provinces, notably Alberta, have reduced corporate tax rates significantly, while others have either not reduced rates, or made more modest reductions. This disparity may affect tax planning as it relates to real estate investments.

The most common legal structures used by non-Canadian investors in Canadian real estate are trusts and corporations. Each of these is discussed below.

Trust. An increasingly common legal structure for investment in Canadian real estate is the trust.

Non-Canadian Trust. In particular, a U.S. or other non-Canadian investor will frequently decide to utilize a U.S. "grantor trust" (or offshore trust) as the vehicle through which an investment in Canadian real estate is made.

Generally speaking, where the investor has acquired a Canadian rental property, the overall income tax rate on rental income will be minimized by using such a trust, even if no other tax planning is done. This is illustrated in the chart at the end of this article.

Furthermore, under current federal and provincial tax laws, trusts are not subject to the capital taxes which are generally imposed on corporations.

Another advantage of a trust is that the "thin capitalization" rules in the Canadian Income Tax Act do not apply to trusts. These rules generally restrict the deductibility of interest on certain related party cross-border debt incurred by corporations unless a specific debt-to-equity test is met. As this rule does not apply to trusts, it is generally possible to capitalize trusts with a greater percentage of debt than would be permitted with a corporation.

The tax treatment of a non-Canadian trust holding Canadian real estate will depend to some extent on whether the income is classified as "business income" or "property income". The Canada Revenue Agency (CRA) will look to a number of criteria to determine whether income from a rental operation should be classified as business income or property income. In general, many factors are considered, including the extent of the services provided to tenants. If a building is rented en bloc with the landlord providing only basic maintenance of the building, heat and air conditioning, income from the rental operation is considered property income. The facts of each case must be considered to determine the appropriate classification of rental income.

Where rental income is classified as property income, this will generally result in a lower tax rate. Furthermore, interest on properly structured related party cross-border debt of the trust will not be subject to Canadian withholding taxes. In appropriate cases, relatively high leverage ratios will enable the owner to significantly reduce the effective tax rate.

However, it is also important to note that the Canadian tax rules do not permit any carry forward or carry back of losses incurred by a non-Canadian trust earning property income.

If a non-Canadian trust is used, there will be some additional compliance burdens to consider. First, unless a discretionary waiver is obtained from the Canadian tax authorities, tenants are technically required to withhold 25% of each gross rental payment and remit that amount to the Canadian tax authorities on account of the tax liability of the non-Canadian trust. There is an election that can be made to be taxed on a net rather than gross basis which will mitigate this withholding, though it will be difficult to entirely avoid it if the trust is earning property income. Furthermore, at the time of sale, the trust will have to apply to the CRA for a "section 116 certificate". Without such a certificate, the purchaser will withhold 25% of the purchase price on account of the trust’s capital gains tax liability. The process of obtaining such a certificate can be managed, but in recent years, it is typical to find that the CRA is backlogged with these applications, and therefore a long lead time is recommended.

Finally, with a non-Canadian trust, it is important to ensure that all mortgage debt is held by Canadian lenders. The "5-year" debt exception usually relied upon to avoid Canadian withholding tax on such debt applies only to corporate borrowers, and not to trusts.

In some cases, a Canadian domestic trust has been used by foreign investors to acquire and hold Canadian real property. Generally speaking, the overall tax rate will be higher than that applicable to a non-Canadian trust. However, such a trust will not be subject to capital taxes or the "thin capitalization" rules. In certain circumstances, a tax exempt investor may be able to achieve a reduced overall tax rate by using a domestic trust by taking advantage of specific exemptions contained in a tax treaty, such as Article XXI of the Canada-U.S. Tax Treaty.

In all cases involving the use of trusts, it is quite important to obtain Canadian tax advice at the outset. Every situation is different. Furthermore, the Canadian tax system is extremely form-driven, and, as a consequence, the tax results in any case can be particularly sensitive to the wording of the relevant legal documents.

Despite the recent popularity of trusts, it is still quite common to see corporations as the vehicle of choice for foreign investors in Canadian real estate. Corporations are well known and well understood by most investors. They offer the most comprehensive and reliable form of limited liability, which is often an overriding concern.

The overall tax rate applicable to an investor who uses a corporation to invest in Canadian real estate will typically be higher than that applicable to an investor who uses a trust. In addition, as noted above, the corporation will typically be subject to federal and applicable provincial capital taxes, although in many markets these can be passed on to tenants in the form of additional rent. Furthermore, the "thin capitalization" rules will effectively require that the corporation be capitalized in a manner that respects the specific debt-to-equity ratio set out in the Canadian Income Tax Act. It is to be noted however that these rules do not apply to bank debt and other loans from unrelated parties.

It is typical for an investor to utilize a Canadian domestic corporation. A Canadian domestic corporation will be less onerous than a non-Canadian trust from a compliance perspective. Tenants will not be required to withhold from their rental payments. On a future exit, the purchaser will not withhold tax from the purchase price, and there will be no need to obtain a "section 116" certificate from the Canadian tax authorities.

A U.S. investor may find it advantageous to use a Canadian "unlimited liability company" (ULC) formed under the laws of Nova Scotia or Alberta. A ULC is a "hybrid" entity – it is treated as a corporation for Canadian tax purposes, but is usually fiscally transparent for U.S. tax purposes (in other words, it is treated as either a partnership or a disregarded entity for U.S. tax purposes). By using a ULC to hold Canadian real estate, a U.S. investor may be able to reduce its overall effective tax rate.

The trust or corporate structure can often be combined with a limited partnership. This is most commonly used in a joint venture situation.

If the current owner of the property intends to retain an interest, such owner will typically request that a limited partnership be used so that the property can be contributed into the limited partnership on a tax deferred basis. It is important to note that the Canadian tax rules permit such a tax deferred transfer only where all of the participants in the limited partnership (including any non-resident investors) have participated through a Canadian resident vehicle (such as a domestic trust or a domestic corporation). In many cases, this will effectively limit the choice of vehicles available to a non-Canadian investor.

It is also important to note that Canada currently takes a different view of LLCs than does the U.S. In particular, while LLCs are generally characterized as partnerships for U.S. tax purposes, they are treated as corporations for Canadian tax purposes. Furthermore, the Canadian tax authorities take the view that no treaty benefits are available to an LLC. This will be the case even where all of the members of the LLC are U.S. taxable corporations or individuals. This anomaly very frequently leads to a need for advance tax planning to avoid later problems.

A non-Canadian investor’s after tax return from an investment in Canadian real estate can depend vitally on the legal structure used. Many factors will need to be considered in order to determine the appropriate structure in a given case. Furthermore, the Canadian tax rules tend not to remain static, and therefore structures that might have been optimal many years ago can sometimes be supplanted by newer structures that adapt to and take advantage of changes in the tax environment.

Attached is simplified chart illustrating 2005 tax rates for an investment in Canadian real estate situated in the province of Ontario. These rates are illustrative only, and are generally based on the most conservative assumptions. They also assume that the owner has done no tax planning to reduce the effective tax rate.

As indicated in this article, many factors and tax planning opportunities will arise in each particular case, and these will ultimately determine the overall effective tax rate.

1. Assumes that all after-tax amounts are distributed and no tax planning such as internal debt financing to reduce effective rate. Also assumes the investor has no treaty protection (e.g. , LLC). Rates vary by province and from year to year.

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.