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FROM PRINCIPLES TO PLANNING Cross-Border Ownership of Real Estate - Canada FROM PRINCIPLES TO PLANNING.

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Presentation on theme: "FROM PRINCIPLES TO PLANNING Cross-Border Ownership of Real Estate - Canada FROM PRINCIPLES TO PLANNING."— Presentation transcript:

1 FROM PRINCIPLES TO PLANNING Cross-Border Ownership of Real Estate - Canada FROM PRINCIPLES TO PLANNING

2 Investing in Canadian Real Estate Glenn Willis, MNP LLP

3 Real Estate Investments in Canada Over the last 10 years or so, Substantial investment activity by Non-residents of Canada in Canadian rental properties and development projects Objectives of selecting the appropriate vehicle to hold the property are: (i)Minimize Canadian taxes on profits (ii)Minimize Canadian non-resident withholding taxes (iii)Maximize foreign tax credits in the jurisdiction of the investor The tax consequences to a Non-resident investor depends on whether the income is earned from carrying on business in Canada or whether the income is income from property 3

4 Business Income vs. Property Income Starting point of the Canadian tax analysis Question of fact (Not a question of law) The range of services test (a primary test) (Wertman v. MNR) Generally, if only basic services are provided to tenants, then rental income earned is likely property income The level-of-activity test (a secondary test) (Radke Bros. Construction Co. Ltd. V. MNR) i.e. The time and labour devoted by the taxpayer to the enterprise The size or number of properties being rented by the landlord does not alter the nature of the rental income The owner’s delegation of its management and supervision to service providers does not alter the nature of the rental income Incidental rental income or loss is considered to be part of a taxpayer’s business income or loss if a taxpayer carries on business and rents property that is incidental to or part of the business operations 4 Business Income vs. Property Income

5 Business Income—Why Important? Non-resident is subject to Canadian Part I income tax on the income earned in Canada 2013 T AX R ATES 5 C ORPORATE 25-31% (depending on applicable provincial tax rate) plus branch tax I NDIVIDUAL 20-50% (marginal rates and applicable provincial tax rate) T RUST 39-50% (depending on applicable provincial tax rate) Business Income—Why Important?

6 Business Income—Why Important? - continued A waiver (granted at discretion of the Canada Revenue Agency “CRA”) under regulation 805 could be obtained to avoid withholding taxes on the rents payment to a Non-resident (discussed more under property income) Where a Non-resident pays an amount to another Non-resident, the first Non- resident will be deemed to be a person resident in Canada for withholding tax purposes for the portions of the amount that is deductible in computing the first Non-resident’s income earned in Canada Where a Non-resident pays interest on a mortgage secured by real property in Canada and the interest is deductible by the Non-resident in calculating taxable income earned in Canada, the payer i.e. the Non-resident is deemed to be a resident in Canada for withholding tax purposes Losses can generally be carried forward or carried back 6 Business Income—Why Important? - continued

7 Property Income—Why Important? Basic rule, a Non-resident is subject to a 25% non-resident withholding taxes on the gross rent (final tax) Alternative #1, a Non-resident can file an income tax return within two years after the end of the taxation year to have the final tax liability computed on net rental income for the application year to recover the withholding tax paid in excess of final tax liability 7 Property Income—Why Important?

8 Property Income—Why Important? - continued Alternative #2, a Non-resident can file (annually with the CRA before the beginning of the year) Form NR6 “Undertaking to File an Income Tax Return by a Non-Resident Receiving Rent from Real Property or Receiving a Timber Royalty.” If approved, the Non- resident is subject to a withholding tax of 25% on the estimated net rental income and must file a Canadian income tax return within 6 months after the year end to calculate tax based on the actual net rental income and pay tax at Canadian corporate/individual/Trust rate. If not file, basic rule above of 25% of gross will be assessed with no means of objection. Tenant is responsible for withholding and remitting the tax to the CRA on a monthly basis Rental losses cannot be carried forward or back (can be managed, for example, tax depreciation is a discretionary deduction) 8 Property Income—Why Important? - continued

9 Property Income— continued No permanent establishment in Canada 2013 T AX R ATES 9 C ORPORATE 25% I NDIVIDUAL 22.2% % (marginal rate) T RUST 42.9% Property Income— continued

10 Business Income vs. Property Income Planning Points: There is a general assumption that rental income is income from property unless the facts suggest otherwise A head lease arrangement can be used to increase the likelihood that rental income will be considered property income 10

11 Investment by a Non-resident Corporation Foreign Jurisdictions Canada Canadian Real Estate 11 Corporation Investment by a Non-resident Corporation

12 Investment by a non-resident Corporation – continued If the Non-resident corporation is carrying on a business, the corporation is subject to branch tax Under Article X(6) of the Canada – U.S. Treaty, there is no branch tax on the first $500,000 CDN of income earned by associate companies. Any income in excess is subject to branch tax at a rate of 5% (be careful with U.S. LLC’s unless it can be determined LLC is owned by U.S. C Corp or S Corp) Branch tax is not applicable if the Non-resident corporation earns income from property Non-resident corporations would be subject to capital tax on capital employed in Canada. Historically this was a significant issue as it was an annual tax of.5% on the purchase price of the real estate. Currently, federal and most provinces have reduced the rate to 0% 12 Investment by a non-resident Corporation – continued

13 Investment by a Partnership Canadian Real Estate 13 Foreign Canada Non-resident Entity Partnership Canadian Company debt 100%99.9% 0.01% Investment by a Partnership

14 Investment by a Partnership – continued The jurisdiction where the partnership is formed does not affect the taxation of the partners The Non-resident partner (not the partnership) is subject to Canadian tax Interest income of a Non-resident partner is not subject to Canadian taxation Interest expense is deductible by the partnership in the computation of income The partnership is deemed to be a resident of Canada for purposes of payment of interest, etc. Accordingly, withholding tax will apply if the interest payment is made to a non-arm’s length Non-resident or is with respect to participating debt The CRA has confirmed that they will look through a partnership and allow a U.S. pension fund the treaty exemption (Article XX1) for the proportion of the partnership income allocable to a tax-exempt partner 14 Investment by a Partnership – continued

15 For thin capitalization rules, the debt obligations of the partnership are allocated to the partners in accordance with their proportionate interest in the partnership For Non-resident limited partners, where at the end of a taxation year a partner’s adjusted cost base is a negative amount, the partner is deemed to realize a capital gain equal to the negative amount. As a result, the partner must obtain a certificate from the CRA and pay Canadian tax on the deemed gain 15 Investment by a Partnership – continued

16 Investment by a Non-resident Trust Foreign Jurisdictions Canada Canadian Real Estate 16 Trust debt Investment by a Non-resident Trust

17 Investment by a Non-resident Trust – continued The residency of a trust is determined by reference to where the majority of the trustees exercise central management and control Trust income is calculated as if the trust is an individual. No deduction from income is available for income paid on payable to beneficiaries A trust is a personal trust if the beneficiaries do not pay for their interest in the trust. If the beneficiaries purchase their interest in the trust, then the trust is a commercial trust A personal trust (not a commercial trust) is subject to a deemed disposition of its assets on the 21 st anniversary of the trust 17 Investment by a Non-resident Trust – continued

18 If the non-resident trust earns income from property, it is possible to structure interest on loans from the beneficiaries to not be secured by Canadian property so that interest is deductible and not subject to non-resident withholding tax Non-resident withholding tax will apply on interest paid in the year of sale Subject to proposed thin capitalization rules Otherwise, non-resident withholding tax will apply 18 Investment by a Non-resident Trust – continued

19 Investment by a Canadian Corporation Foreign Jurisdictions Canada 19 Non-resident Entity Unlimited Liability Company (“ULC”) or Limited Liability Company Canadian Real Estate Debt in some circumstances Investment by a Canadian Corporation

20 Investment by a Canadian Corporation – continued Previous discussion regarding business and income property income not applicable Nova Scotia, Alberta and British Columbia permit the formation of an unlimited liability company (“ULC”) Only Alberta require a Canadian resident director For Canadian tax purposes, a ULC is treated the same as a Limited Liability Company For U.S. tax purposes, a ULC is ignored if there is a single shareholder and treated as a partnership if there is more than on shareholder Use of a ULC is desirable if the ULC does not become taxable on the income earned from the real property as a result of deductible expenses (such as, interest and tax depreciation) 20 Investment by a Canadian Corporation – continued

21 The Fifth Protocol to the Canada – U.S. Income Tax Convention (the “Treaty”) denies benefits on dividends, interest and management fees paid by ULCs To avoid subparagraph 7(b) of Article IV of the Treaty on dividends (so called anti-hybrid rules) – Increase the stated capital account for the shares (reported for Canadian purposes as a dividend and remit applicable withholding tax), – Decrease the stated capital account for the shares and distribute amount as a return of capital – no withholding tax Use care in capitalizing the Canadian Corporations, Canada’s thin capitalization rules restrict the deduction for interest paid or payable in a tax year on debts owed to a specified non-resident 21 Investment by a Canadian Corporation – continued

22 For a rental property, interest is not deductible if it relates to a period of construction, however, the interest can be added to the cost of the depreciable property, subject to the thin capitalization rules For a development project, interest is not deductible if it relates to vacant land or if incurred during construction. Accordingly, the thin capitalization rules do not apply Under Article XI of the Treaty, the rate of withholding tax is nil, unless with respect to participating debt Article XXI of the Treaty provides an exemption from withholding tax for interest paid to an exempt organization such as U.S. pension fund that is not related to the payer corporation 22 Investment by a Canadian Corporation – continued

23 A Canadian corporation is subject to tax in Ontario would pay a tax rate of 26.5% on ordinary income and 13.25% on capital gains Under the Treaty, the withholding tax rate on dividends is 5% of the dividend is paid to a corporate shareholder owning at least 10% of the voting stock of the company (otherwise 15%) 23 Investment by a Canadian Corporation – continued

24 To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. IRS Circular 230 Disclosure

25 Questions?

26 Contact Information Glen Willis – MNP LLP William Inchoco - WM


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