Recent Developments Affecting Foreign Investment in Canadian Real Estate

Transcription

1 Volume 66, Number 5 April 30, 2012 Recent Developments Affecting Foreign Investment in Canadian Real Estate by Nathan Boidman and Rhonda Rudick Reprinted from Tax Notes Int l, April 30, 2012, p. 449

2 Recent Developments Affecting Foreign Investment in Canadian Real Estate by Nathan Boidman and Rhonda Rudick Nathan Boidman and Rhonda Rudick are with Davies Ward Phillips & Vineberg LLP in Montreal. This article is the second in an occasional series focusing on tax considerations regarding foreign investment in Canadian real estate. From a tax standpoint, there are several approaches to structuring U.S. and other foreign investment in Canadian commercial real estate. These include direct investment by the foreign party (whether the party is an individual or entity such as a partnership, 1 corporation, or trust 2 ) or indirectly through a foreign or Canadian entity. 3 1 A partnership is not a taxpayer under Canadian law. Under section 96 of the Income Tax Act, R.S.C. 1985, c.1 (5th Supp.), as amended, its income is allocated to its partners and taxed in their hands. In limited circumstances (for example, rules under Part XIII of the ITA dealing with the payment by Canadian residents to nonresidents of certain items of passively earned income (for example, interest or dividends)), a partnership may (as payer or payee) be deemed to be a Canadian resident taxpayer. 2 Under the law of trusts in Canada and most countries, a trust is not an entity per se but, instead, a fiduciary relationship. Section 104 of the ITA effectively treats a trust arrangement as a separate person that is a taxpayer and is considered to be resident in the place where it is managed and controlled, which normally would be the place where its trustee(s) is based. 3 For a detailed examination of each of these approaches, see Nathan Boidman and Rhonda Rudick, Planning for Investment in Canadian Real Estate by Nonresidents, Tax Notes Int l, Sept. 20, 2010, p. 967, Doc , or2010 WTD Indirect investment arrangements provide varying results, depending on all the facts and circumstances, during the holding/operational phase in which earnings stripping/internal financing arrangements often play a key role 4 and at the point of disposition. One of these approaches, the use of a nonresident trust, has just potentially become more expensive and inefficient from a tax standpoint when the property is located in Québec, Canada s second largest province. This arises from a budget handed down by the Québec 4 The nature and context regarding such arrangements is as follows. If a foreign corporation (Forco) were directly acquiring a Canadian property at a price of $10 million, borrowing $7 million, at a 5 percent interest rate from a third-party financial institution (FI) and providing $3 million of its own funds, Forco would incur $350,000 of interest expense, deductible against the rental income from the building. If instead Forco established a corporation or a trust (whether inside or outside Canada) to purchase the property and to borrow the $7 million from the FI and Forco provided, say, $1.5 million to the entity as capital and $1.5 million as a loan at, say, 10 percent (and observing both thin capitalization rules, discussed further below, and arm s-length pricing standards), the entity would have, as a deductible financing expense, both the $350,000 payable to the FI and $150,000 payable to Forco. TAX NOTES INTERNATIONAL APRIL 30,

3 PRACTITIONERS CORNER government on March 20, 2012, which, coupled with other recent developments, serve to make the use of a foreign trust, particularly for U.S. investors, less attractive than previously. This report briefly reviews the parameters and some of the specifics regarding the Québec announcement as well as two other recent developments affecting the relative benefits of investing through a nonresident trust as compared with a nonresident corporation. The most recent development is that contrary to expectations, the federal government, in adopting in its March 29 budget a number of recommendations regarding Canada s thin capitalization rules, made by a 2008 government-appointed advisory panel on reform of Canada s international tax rules, 5 did not move to extend the thin capitalization rules to loans made to trusts, although the government did table a proposal to reduce the statutory debt-equity ratio from 2 to 1 to 1.5 to 1. The other recent development pertains to declining corporate tax rates in Canada. I. Background: Structuring Approaches Direct foreign investors pay taxes at rates ranging from a low of 25 percent for corporations (although those rates may be higher in some circumstances) to a high of almost double that for individuals and trusts (although those rates may be lower in some circumstances) on net income generated from owning/ operating Canadian commercial real estate. 6 On selling such property (and held as an investment and not in a speculative buy and resell context 7 ), such 5 Nathan Boidman, Reforming Canada s International Tax Regime: Final Recommendations, Part 1, Tax Notes Int l, Jan. 19, 2009, p. 247, Doc , or 2009 WTD 12-16; Nathan Boidman, Reforming Canada s International Tax Regime: Final Recommendations, Part 2, Tax Notes Int l, Jan. 26, 2009, p. 345, Doc , or 2009 WTD 15-11; and Nathan Boidman and Marc Darmo, How Are Multinationals Faring Under Canada s Incomplete International Tax Reform? Tax Notes Int l, June 13, 2011, p. 901, Doc , or2011 WTD In some cases an election is required to access this regime, failing which the tax is a flat 25 percent on gross rentals (without deductions for cash expense or depreciation). A nonresident is entitled to this regime if income realized from Canadian commercial real estate is considered to be derived from carrying on business in Canada through a permanent establishment (as defined in the ITA for this purpose). In any other case that is, when there is business income that does not entail a PE (a situation not recognized by the Canada Revenue Agency) or nonbusiness income (known as income from property) the regime is available provided a timely election is made under section 216 of the ITA. The distinction between business income and property income is made by case law as detailed in the article (supra note 3). 7 Property held as an investment is known as capital property, per section 54 of the ITA. The distinction between such property and non-capital property is made by a large body of investors pay tax determined by applying the foregoing rates to half the gain from disposition. Such (direct) investment format harbors certain potential tax inefficiencies, in comparison with the possible range of results in which indirect investment is chosen. These include the inability to structure taxreducing internal financing arrangements (see supra note 4), possible double tax on dispositions involving property located in Québec and investors that are foreign trusts or foreign corporations (as detailed below), and taxes on death when the direct investor is an individual. 8 Indirect investment format can, in some circumstances, provide a combination of: the tax rate/burden range noted above; facility to inject a portion of the equity investment as internal interest-bearing debt that reduces net taxable income in a material fashion (see supra note 4) without the negative effects of withholding taxes 9 ; avoidance of double tax on dispositions; and avoidance of tax on death. 10 Depending on all the circumstances, indirect structures might see Canadian or foreign corporations or trusts or a combination of the two (with or without flow-through partnerships or accessory internal net leases or internal debt coming into one entity in the structure or instead into two). case law, which looks both at intentions at the point of acquisition and at the actual course of conduct during the hold and disposition phases. 8 Canada s tax at death takes the form of the deceased being treated as having sold property at fair market value immediately before death and paying tax, as described above on the ensuing deemed capital gain. See section 70 of the ITA. The tax can be deferred if the foreign individual has a Canadian resident spouse and the property is bequeathed to such spouse or a Canadian trust established for such spouse. Canada abolished conventional estate or succession taxes at the federal level in 1972 and at the level of the provinces in years thereafter. 9 This is discussed below. 10 Note, however, that the use of an entity does not necessarily insulate a foreign individual from Canada s deemed disposition rules at death. Under the ITA there will be potential liability to tax if the interest held at death by a nonresident individual is taxable Canadian property, which includes interests in corporations or trusts, regardless where resident, if the value of the interest is primarily derived from Canadian real property or had been within the prior five-year period. Certain interests in publicly traded entities or interests in non-canadian corporations owned by persons who are qualifying residents of the U.S. under the Canada-U.S. income tax treaty (and perhaps individuals in a few other treaty country situations) may be excluded from such potential liability. However, when a trust is involved, regard is, separately, required as to whether a rule that deems certain trusts to dispose of their property every 21 years is applicable. (Footnote continued in next column.) 450 APRIL 30, 2012 TAX NOTES INTERNATIONAL

4 II. Québec Budget Proposals The Québec budget released on March 20, 2012, will change the way nonresident inter vivos trusts owning Québec real estate are taxed. These changes affect the taxation of rental income as well as gains on disposition. A. Income From Property Before the budget, nonresident trusts owning real estate in Québec were not taxed in Québec on rental income that did not constitute business income (see supra note 6) because Québec generally only taxes nonresidents of Canada on income earned through an establishment in Québec. That generally requires the earning of business income. 11 Accordingly, before the budget, nonresident trusts earning income from property only paid federal tax at a rate of 29 percent plus a surtax of 48 percent (which is meant to approximate provincial tax) for a combined rate of percent. 12 As a result of the budget proposals, there will now be an additional 5.3 percent Québec tax for a combined rate of percent, the same rate that a trust resident in Québec would pay. 13 The rationale for this change as set out in the budget is Québec s view that it should share in the revenues from property located in the province. This change is consistent with the taxation of nonresident corporations owning real estate in Québec used principally for the purpose of earning or producing gross revenue that is rent, as such corporations are deemed under the Taxation Act (Québec) (QTA) to earn income from an establishment in Québec and are thus subject to Québec taxation on passive rental income. 14 Under the budget proposals, there is a look-through when income is earned by the nonresident trust through a partnership. The budget also provides that nonresident trusts owning Québec real estate must file tax returns in Québec, even if no tax is payable, for years ending after budget date. B. Dispositions Regarding dispositions, nonresident trusts owning Québec real estate are subject to double taxation on PRACTITIONERS CORNER any capital gain on disposition. First, there is the federal tax and surtax with a combined rate of percent described above applicable to 50 percent of the gain for a combined effective rate of percent. Second, Québec taxes half of the gain on disposition on the basis that the property constitutes taxable Québec property at a rate of 24 percent for a net rate of 12 percent, producing a combined rate of percent. 15 In contrast, if the gain were realized by a trust resident in Québec the effective rate would be percent (half of percent) or some 9 percentage points lower. That is the measure of the double tax faced by nonresident trusts, selling Québec real estate. 16 In order to avoid such double taxation on dispositions, as well as to avoid the requirement of obtaining clearance certificates or withholding under section 116 of the Income Tax Act and sections 1097 and following of the QTA, such trusts are often migrated to Canada before a sale (for example, by moving the central management and control of the trust 17 ). If a nonresident trust is migrated to a Canadian province other than Québec, no Québec tax is payable on the gain on disposition. The Québec budget states that such planning deprives Québec of a source of revenue, generally in favor of a province with a lower tax rate. 18 To deal with this potential loss of revenue, the budget proposals provide for a deemed disposition of the property immediately before migration, such that Québec tax will be payable on inherent gains and recapture at such time. If migration is to Québec, this will accelerate the Québec tax but results in no double taxation. However, if the trust is migrated to another province, double taxation will result. The budget does not specify if the deemed disposition will apply if the trust owns the immovable through a partnership. This rule applies to migrations after the budget date. As an enforcement mechanism, the budget proposals specify that a Québec clearance certificate will be required to be obtained by a migrated trust that disposes of Québec real estate; otherwise the purchaser can be liable for withholding tax (generally 12 percent of the 11 Exceptionally, noted in the text below, foreign corporations owning commercial Québec real estate have long been deemed to have establishments in Québec so as to engage that nexus rule. 12 As indicated earlier (supra note 6), this regime of taxation requires that the taxpayer make an election under section 216 of the ITA, failing which there would be a tax of 25 percent of gross rental income. 13 In particular, a specified trust defined as an inter vivos trust that did not reside in Canada at any time during the year and which is not tax exempt, will pay an additional 5.3 percent tax on income from specified immovable property, which is defined as an immovable located in Québec that is used mainly for the purpose of earning or producing gross revenue that constitutes rent. 14 Section 12 of the QTA. 15 This rate is based on the highest marginal rate applicable to individuals in Québec. The budget proposals provide that the highest marginal tax rate applicable to individuals will be applicable to all income earned by inter vivos trusts in Québec in order to avoid the possibility of income splitting with an inter vivos trust by benefiting from marginal rates. 16 While a remission order is available for individuals to avoid this double tax, the CRA and the Department of Finance take the position that a trust is not an individual for this purpose and that the remission order is only available for natural persons. 17 See supra note 2 regarding the residency of trusts. 18 If the trust is migrated to Ontario, the combined tax rate on disposition is percent and in Alberta the combined rate is 39 percent as compared with percent for a trust resident in Québec. TAX NOTES INTERNATIONAL APRIL 30,

5 PRACTITIONERS CORNER purchase price, subject to a reasonable enquiry exception). Thus, a purchaser should request a representation not only that a vendor trust is resident in Canada at the time of sale, but that it has been resident in Canada at all times since it acquired the property in order to rely on the reasonable enquiry exception. III. Effects of Other Developments A. The Question of Tax Rates The higher tax rate payable by nonresident trusts (both pre- and post-budget in Québec and elsewhere in Canada) can be contrasted with the new reduced tax rate payable by nonresident corporations. 19 Leaving aside Québec, a nonresident corporation pays tax on income from property only to the federal government, and at a rate of 25 percent. 20 This is significantly lower than the percent rate payable by nonresident trusts owning Canadian real estate that generate income from property. Moreover, one of the principal reasons for using a trust in many provinces was to avoid tax on capital, which has now been abolished in all provinces. While a nonresident corporation is subject to branch tax on business income, such tax is not applicable to income from property. Turning now to Québec: How does the new percent rate for nonresident trusts stack up against other structuring formats? If a foreign corporation earns passive rents in Québec, the federal rate under a section 216 election will be the above noted 25 percent and there will also be (as discussed above) Québec corporate tax at the rate of just under 12 percent for a total of 37 percent. B. Financing Factors The vast difference between rates on foreign corporations and foreign trusts earning rental income that comprise property income in provinces other than Québec and the not insignificant difference when Québec is involved would seem to clearly favor (militate toward) corporations over trusts. But there are two uncertainties relating to internal debt financing that may affect many specific situations and choices. 19 Between 2001 and the beginning of this year, the basic federal rate of tax declined by 13 percentage points from 38 percent to 25 percent. That rate is reduced by a further 10 percentage points when the taxpayer has a PE in a province (and thus pays tax to that province). Most provinces have rates in the percent area and that gives rise to aggregate rates of roughly percent for a corporation carrying on business in a province through a PE. Note that unlike the U.S., the provincial taxes are not deductible in computing taxable federal income but are applied to a common income base. 20 That is the rate set out in the prior note as being the base federal rate before reduction for income earned in a province through a PE. First, the thin capitalization rules of section 18(4) of the ITA do not apply to internal loans to trusts and as noted above, the federal government s March 29 budget did not propose to change that. 21 As well, and again unexpectedly, the federal budget did not propose to extend those rules to loans made to corporations that are not resident in Canada. That should mean that they do not apply to loans made to a foreign corporation that elects under section 216 of the ITA. The problem, however, is that section 216 of the ITA provides for net income taxation by rules that apply as if the corporation were resident in Canada (without specifically deeming such status), and, as a result, the Canada Revenue Agency takes the position that the thin capitalization rules do apply to foreign corporations that elect under section 216 of the ITA. Therefore, that puts into question whether a foreign corporation can achieve the same substantial leverage/ benefits from internal debt that is available to a nonresident trust. This makes it unclear whether in the foreign corporation versus foreign trust comparison the benefits of the lower corporate tax rates would be reduced or eliminated by lower internal interest deductions. Second, because of a rebuttable presumption of business regarding corporations which does not apply to trusts there is more risk that the use of a foreign corporation will trigger a deeming rule that can give rise to withholding tax on internal interest payments. Under the ITA, interest paid by a resident of Canada to a non-arm s-length nonresident 22 is subject to a 25 percent withholding tax. A nonresident that carries on business in Canada and deducts interest payments in relation thereto or pays interest (that is deductible in Canada) on debt secured by Canadian real estate is deemed to be a resident of Canada for purposes of that withholding tax rule. 23 Exceptionally, a U.S. lender to a controlled corporation or trust that 21 Canada limits the amount of interest that a Canadian resident company can deduct regarding loans from 25 percent or greater foreign shareholders or affiliated parties. That is by disallowing a deduction, under section 18(4) et seq. of the ITA for interest on the portion of such loans that exceeds the aggregate of twice the share capital investment in the corporation attributable to such shareholders and all of the corporation s retained earnings. As noted above, the March 29 federal budget proposes to reduce that 2-1 ratio to 1.5 to The notion of arm s length is partly statutory and partly case law made. Persons who are related as defined in section 251(2) of the ITA such as a corporation and a controlling shareholder are deemed not to deal at arm s length, under section 251(1) of the ITA, as is a beneficiary of a trust and a trust. And unrelated persons may, as a matter of the facts (such as lack of separate economic interest in a particular arrangement), be considered to not deal at arm s length. 23 Section 212(13)(f) of the ITA and section 212(13.2) of the ITA. 452 APRIL 30, 2012 TAX NOTES INTERNATIONAL

6 owns Canadian real estate would be exempt from such tax under Article XI of the treaty provided the interest is not contingent. However, in other cases there would be at least a (treaty-based) 10 percent withholding tax and 25 percent when there is no such treaty. In such case the foreign investor, in considering a foreign corporation or a foreign trust to own commercial Canadian real estate, would wish to avoid both of the deemed Canadian residency rules. That under section 212(13.2) of the ITA is easier to avoid when a foreign trust rather than a foreign corporation is used because of the presumption of business that applies to a corporation. The use of internal net lease arrangements may serve to eliminate this second issue. Therefore, the bottom line is that higher tax rates on foreign trusts than on foreign corporations may not always mean that a foreign corporation is preferable to a foreign trust. The comparisons become more complex when business income is earned and a federal branch tax may apply to a foreign corporation 24 or when a structure entails Canadian resident trusts or corporations and 24 A nonresident corporation that carries on business in Canada (with or without a PE as domestically defined) is subject under section 219 of the ITA to an additional tax, over and above mainstream tax, computed as 25 percent of, in general, the excess of taxable profit over the aggregate of the mainstream tax and the amount of profit that has been reinvested in the business. This is a type of proxy for the tax that would be imposed on dividends paid by a Canadian resident corporation to a foreign corporate shareholder were that party to carry on business in Canada through such subsidiary rather than directly (through a branch ). This tax does not apply to a foreign corporation s Canadian rental income that is considered to comprise income from property as above. It is an open question as to how this tax would apply to a foreign corporation that has rental income considered to arise from carrying on business in Canada without a PE (a circumstance which, as noted above, is rejected by CRA, but which has been recognized by courts), particularly if the corporation were not to elect, under section 216 of the ITA, to pay tax on a net income basis. PRACTITIONERS CORNER additional considerations involving loans to trusts 25 and withholding taxes on dividends 26 arises. C. Dispositions The comparative results for foreign corporations selling Québec real estate may be drawn from the rates noted above for aggregate rates on rental income. The aggregate 37 percent rate applied to half the gain would produce a net rate of 18.5 percent or some 15 percentage points lower than the percent applicable to a nonresident trust. But again, account would have to be taken of the potential disadvantages of a foreign corporation set out above. IV. Concluding Comments The initial installment in this occasional series (see supra note 3) regarding the taxation of foreign investors in Canadian real estate made clear that the relevant Canadian tax rules (and, when relevant, associated tax treaty rules) are complex but, depending on the circumstances, sometimes amenable to effective taxstructuring and planning. The foregoing review of recent Québec and federal developments indicates that although there may be more onerous results for investors in Québec real estate, and a general negative implication from the planned reduction in the thin capitalization ratio, both the abstention from extending thin capitalization rules to trusts and to foreign corporations (that is clear when a foreign corporation carries on business in Canada), and declining corporate tax rates auger well for the potential to fashion effective structures, from the tax standpoint, for foreign investment in Canadian real estate. 25 Section 15(2) of the ITA includes in income a loan made by a corporation to a shareholder that is not repaid by the end of the tax year following the year in which it is made. Because of drafting glitches, this rule can cause (inadvertently) a loan made to a Canadian resident trust by a beneficiary of an affiliated party to be included in the income of the trust. In some circumstances, steps can be taken to avoid this trap. 26 As noted above, there is a tax on the gross amount of dividends paid by a Canadian resident corporation to a nonresident shareholder, levied at the rate of 25 percent. See section 212(2) of the ITA. Treaties (for example, with the U.S.) may reduce that to 15 percent in general and 5 percent for dividends paid to corporate shareholders with specified levels of share ownership. In the case of U.S.-owned Canadian corporations hybrid entities such as U.S. LLCs or Canadian unlimited liability companies may render complex treaty rules (for example, Article IV(6) and (7) of the treaty, introduced by the 2007 protocol) applicable. As well, the U.S. inspired (anti-treaty-shopping) limitation on benefit rules may complicate the tax analysis and results. TAX NOTES INTERNATIONAL APRIL 30,