UPDATE ON NON-RESIDENT INVESTMENT IN CANADIAN REAL ESTATE

Transcription

1 Page 1 of 8 UPDATE ON NON-RESIDENT INVESTMENT IN CANADIAN REAL ESTATE Jack Bernstein Aird & Berlis LLP Toronto, Canada The stable Canadian political environment and currency together with low interest rates have attracted many foreign investors to acquire Canadian real estate directly or through funds. We have acted on many transactions in the last two years for American, German, Israeli, French, Chinese and Middle Eastern investors. They have invested in existing real estate funds in Canada, directly into properties or through international funds structured specifically for nonresident investors in Canadian real estate. The types of properties acquired have included multiresidential, development (condominium) hotels and casinos. Investment by a Canadian Corporation A non-resident of Canada may incorporate a Canadian corporation to acquire Canadian real property. A U.S. purchaser might consider using an unlimited liability company ( ULC ) for that purpose. Investors must use care in capitalizing the Canadian corporation. Although interest expense incurred for the purpose of acquiring a rental property generally is deductible for Canadian tax purposes, Canada has thin capitalization rules that operate to disallow an interest deduction to the extent that the corporation is thinly capitalized. Subsection 18(4) of the Income Tax Act (Canada) ( ITA ) sets out Canada s thin capitalization rules and restricts the deduction for interest paid or payable in a tax year by a corporation resident in Canada on debts owed to a specified non-resident. If the ratio of those debts to the corporation s equity exceeds 1.5 to 1, the excess interest is not deductible and may be treated as a dividend subject to Canadian withholding tax. The rules are complicated and require the corporation to calculate average monthly amounts. Equity includes the retained earnings at the beginning of the year, the average of contributed surplus at the beginning of a calendar month, and the average of paid-up capital at the beginning of a calendar month. A specified non-resident is a non-resident person or a nonresident owned investment corporation that is a shareholder of the corporation that alone, or together with non-arm s length parties, owns shares with a minimum of 25% of the votes or 25%

2 Page 2 of 8 of the fair market value of all the issued and outstanding shares of the corporation. There are anti-avoidance provisions in the thin capitalization rules which extend their application to catch back-to-back loan arrangements. A Canadian corporation that is controlled by a non-resident would not be a Canadiancontrolled private corporation. As a result, such corporation would not be entitled to benefit from the small business deduction, which results in a low tax rate - approximately 15.5% in Ontario - on the first $500,000 of active business income. It also would not be entitled to receive a dividend refund on the payment of dividends out of investment income. As a result, such corporation would be subject to the top Canadian corporate tax rate. A Canadian corporation subject to tax in Ontario would pay a combined federal and provincial corporate tax rate of 26.5% on ordinary income. Capital gains are effectively taxed at half this rate, or currently 13.25%. The aggregate corporate and withholding tax on a capital gain realized in a corporation controlled by a non-resident and fully distributed would be approximately 17.59% (if a 5% withholding tax rate applied to the dividend), 26.26% (if a 15% withholding tax rate applied to the dividend) and 34.94% (if a 25% withholding tax rate applied to the dividend). The aggregate corporate and withholding tax on recaptured depreciation or inventory gain realized in a corporation and distributed as a dividend would be approximately 30.18% (if a 5% withholding tax rate applied to the dividend), 37.53% (if a 15% withholding tax applied to the dividend) and 44.88% (if a 25% withholding tax rate applied to the dividend). Taxable Canadian Property A non-resident of Canada who proposes to dispose of or disposes of taxable Canadian property including real property situated in Canada (other than excluded property) or shares of a Canadian corporation if more than 50% of the value of the shares is derived from real property situated in Canada must apply under section 116 of the ITA for a Certificate of Compliance (the Certificate ) from the Canada Revenue Agency ( CRA ) at any time before the disposition or within 10 days after the disposition. Under most of Canada s treaties, Article 13 of the relevant treaty will provide that gains from the alienation of any property, other than real property or personal property forming part of

3 Page 3 of 8 a permanent establishment or a share of a capital stock of a company (the value of which share is derived principally from real property situated in Canada), shall be taxable only in the contracting state of which the alienator is a resident. Some of Canada s treaties apply to exempt from Canadian tax dispositions of shares in publicly-traded companies the value of which is derived principally from immovable property. See for example, Austria, Belgium, Croatia, Estonia, Germany, Hungary, Iceland, Ireland, Kazakhstan, Kuwait, Kyrgyzstan, Latvia, Lithuania, Luxembourg, the Netherlands, Slovenia, South Africa, Sweden, Switzerland, Tanzania, Ukraine, the United Kingdom, Uzbekistan and Venezuela. * As mentioned above, there is no requirement to obtain a Certificate in respect of dispositions of a taxable Canadian property which is excluded property. Excluded property includes a share that is listed on a recognized stock exchange. A recognized stock exchange includes a designated stock exchange and any stock exchange in an OECD country with which Canada has a tax treaty. As a result, even though a gain on the disposition of shares of a public corporation the shares of which derive more than half their value from Canadian real property is taxable in Canada where at anytime of the 60-months prior to the date of disposition the vendor, alone or together with non-arm s length persons, owns more than 25% of the shares of a class, there is no requirement to obtain a Certificate in these circumstances. Therefore, the purchaser of the shares can have no liability if the vendor fails to pay its Canadian taxes in connection with the disposition. Some treaties exempt non-resident shareholders who own less than a certain percentage (often 10% and sometimes 25%) of the shares of a Canadian private corporation that derives its value from Canadian real property from Canadian tax on any gain realized in the sale of such shares (see for example, Austria, Belgium, Denmark, Germany, Korea, Luxembourg, Mexico, Russia, Switzerland and the United Kingdom * ). Other treaties provide relief from Canadian taxation on gains arising from the disposition of movable property such as shares (other than movable property forming part of the business property of a permanent establishment) whether or not the value of the shares is derived principally from immovable property in Canada (for example, Algeria and Bulgaria * ). * This is not a complete list. * This is not a complete list.

4 Page 4 of 8 Article XIII of the Canada-Luxembourg Treaty also exempts the gain from the sale of shares of a Canadian corporation where the underlying real estate is used in the business of the corporation (e.g., a hotel, nursing home). Use of a Non-Resident Corporation A non-resident corporation that carries on business in Canada is required to file a Canadian income tax return annually and pay tax under Part I on its net income. Whether a nonresident corporation which owns rental property in Canada carries on business in Canada is a question to be determined from all the facts and circumstances. The weight of authority favours the provision of services test as the relevant test in determining whether rental income is income from business or income from property. For example, income from a hotel or nursing home would be income from a business. Income from an apartment building, industrial building or self-storage business would generally be income from property. If the non-resident corporation is carrying on a business, in addition to ordinary corporate tax, the corporation is subject to branch tax at a 25% rate, unless modified by a treaty. Branch tax is imposed to ensure that the non-resident does not avoid the tax that would otherwise have been withheld on dividends paid by a Canadian corporation. Under Article X(6) of the Canada-US Tax Treaty, there is no branch tax on the first $500,000 Cdn. of income earned by associated companies. Any income in excess of that amount is subject to branch tax at the 5% rate. The reduced rates do not apply to a U.S. LLC. If the non-resident corporation earns income from property, payments of rent made by a resident of Canada to the non-resident are subject to Canadian withholding tax of 25%. Branch tax will not apply to income from property. However, a non-resident who earns income from property is entitled to file an election for rental income under section 216 of the ITA. Rather than have the Canadian withholding tax at the 25% rate on the gross rental income, the election permits withholding on net rental income. The non-resident may deduct non-capitalized expenses for interest relating to the property, property taxes, and property management and maintenance fees in computing the net rental income subject to withholding. The CRA takes the position that capital cost allowance (depreciation) is not deductible for the purpose of

5 Page 5 of 8 determining net rental income subject to withholding tax. However, capital cost allowance should be deductible on filing the Canadian income tax return as discussed below. In order to make the section 216 election, the non-resident must undertake to file a Canadian tax return and pay Part I tax on its net income. A non-resident corporation that elects under section 216 is taxed as if the corporation were a corporation resident in Canada. When the section 216 election is made, the thin capitalization rules apply to restrict the debt to equity ratio of the non-resident corporation to 1.5 to 1. A non-resident corporation may not be the appropriate vehicle for investment in real estate in the Province of Quebec. Quebec is the only province with a separate tax system. Quebec does not have the equivalent of a section 216 election. A non-resident corporation earning rental income in the Province of Quebec will be deemed to have a permanent establishment in the Province. It will be subject to Quebec corporate tax at the rate of 11.9% and will not be eligible for the provincial abatement from Federal tax. The aggregate tax rate in Quebec may be approximately 37% (25% tax if a section 216 election is made plus the Quebec corporate tax). The shares of a non-resident corporation, the value of which is derived primarily from Canadian real estate, will be taxable Canadian property. Use of a Trust A trust often is viewed as an attractive vehicle as it is not subject to branch tax. The beneficiaries or other non-residents may loan funds to the trust on an interest-bearing basis subject to the 1.5-to-1 debt-to-equity ratio. However a non-resident trust will pay more tax on a sale than a non-resident corporation (24.8% vs 13.25% when considering combined federal Ontario rules). In 2012, the Province of Quebec targeted non-resident trusts owning Quebec rental properties and enacted legislation to subject such trusts to the top provincial personal tax rate which is currently 49.97%. As a result of the 2012 Budget, the rental income of the trust will be deemed to be earned through an establishment in Quebec. A non-resident trust owning Quebec real estate will be required to file a tax return in Quebec even if no tax is payable. If a nonresident trust is migrated to Canada, it will be deemed to dispose of its rental immovable

6 Page 6 of 8 property located in Quebec from proceeds of disposition equal to fair market value and a clearance certificate will be required. Generally, the residency of a trust is determined by reference to the residency of the majority of the trustees. However, in St. Michael Trust Corp. v. The Queen, 2012 DTC 5063, the Supreme Court of Canada held that the residency of a trust is determined by applying the same test used for corporations, namely, a trust is resident where it centrally managed and controlled. A non-resident trust may be deemed to be a Canadian resident when the trust has either a resident contributor (generally, a person resident in Canada who directly or indirectly makes a gift, loan, or transfer of property to a non-resident trust) or a resident beneficiary (a Canadian resident beneficiary). If the trust earns income from property, then it arguably is not subject to provincial tax, but will be subject to a federal surtax of 48% which applies to income not earned in a province. The rate of tax in those circumstances would be 42.92% based on current rates. It is beneficial to have the non-resident trust earn income from property and not carry on a business in Canada. For non-resident trusts earning income from property, it is possible to structure interest on loans from the beneficiaries to not be secured by Canadian property so that an interest deduction may be claimed on filing the net election under section 216 of the ITA. Subsection 212(13.2) will apply to require Canadian withholding tax on interest paid on a rental property in the year of sale. Use of a Partnership If a partnership with a non-resident member invests in Canadian real property, the tax consequences depend on whether the income from the real property is earned from carrying on business in Canada, or whether the income is income from property. It may depend also on whether any partner is a taxable corporation. From a Canadian tax perspective, the jurisdiction or formation of the partnership does not affect the taxation of the members.

7 Page 7 of 8 If any of the partners in the partnership are corporations and the partnership earns income from a business, the corporate partners will be subject to Canadian tax at corporate rates (currently 26.5% in Ontario) under Part I of the ITA and Canadian branch tax. If the partnership is viewed as earning income from property rather than income from a business, the non-resident partner will be taxable under Part XIII (the Canadian withholding tax provisions) on the gross rental income. However, rather than have Canadian withholding tax on gross rental income, it is generally preferable for the partnership to elect under section 216 of the ITA for its income to be taxed on a net basis. That would result in the non-resident partners being subject to Canadian tax under Part I of the ITA on their net income from the Canadian property, and they would be required to file Canadian tax returns annually. In addition, the withholding tax should be reduced or eliminated as discussed above. The partnership may be required to withhold tax on interest paid by it to a partner under subsection 212(13.1). If the partnership is earning property income but does not make the section 216 net election in Canada, any payment by a Canadian resident to the partnership is deemed to be a payment to a non-resident for withholding tax purposes. Part XIII withholding tax should not apply if the partnership is paying tax under Part I as business income, provided the appropriate waiver is obtained from the CRA under regulations 805 and The thin capitalization rule relating to the financing of a Canadian corporation extends to the financing of a partnership which has Canadian corporate partners. For this purpose, the debt obligations of the partnership are allocated to the partners in accordance with their proportionate interests in the partnership. Therefore, if the non-resident lender owns at least 25% of the shares of a Canadian corporate partner, the thin capitalization rules will apply. If a partnership with any non-resident members disposes of taxable Canadian property (such as real property situated in Canada or a partnership interest discussed above), one application for a Certificate in Form T2062 may be filed on behalf of all partners. It must include a complete listing of the non-resident partners, their addresses, tax identification members, interest (percentage) in the partnership, adjusted cost base and proceeds of disposition and payment of the tax or security for the payment of tax. Even if full tax is to be paid it is not possible to obtain a Certificate and to avoid 25% withholding by the purchaser on the gross sales

8 Page 8 of 8 price if information cannot be provided on all partners. This is a practical problem if a partner is another fund. If a tax identification number (TIN) is required, an original or certified copy of a valid passport, valid drivers licence or birth certificate must be provided. Technically, the application is being made for each partner as each member of the partnership is considered to have disposed of his share of the property. This means that each partner has to file a Canadian tax return in the year of disposition reporting his share of the gain or loss from the disposition. This has created a practical compliance problem for large partnerships which have other arm s length partnerships as partners. Information may not be available on every partner in a fund. The requirement to obtain a Certificate on behalf of each partner and the requirement for each partner to file a Canadian return militates against the use of a partnership as a practical structure to own Canadian real property, particularly where there are many partners. The use of a corporate blocker outside of Canada (e.g., a company in Luxembourg or in the British Virgin Islands or possibly a US LLC) would avoid the disclosure requirements above as the blocker would be the only tax filer in Canada. As Canadian tax is not reduced, the interposition of the blocker should not be considered abusive tax planning