TAX LAW / INVESTMENT FUNDS BULLETIN CANADA EXTENDS SOURCE TAXATION FOR INVESTMENT FUNDS

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1 February 9, 2005 CANADA EXTENDS SOURCE TAXATION TAX LAW / INVESTMENT FUNDS BULLETIN The Department of Finance released on December 6, 2004, draft legislation (the Amendments ) implementing the March 23, 2004 Budget proposals (the Budget Proposals ). This note will describe the Amendments directed at the investment fund sector, and principally, income trust investments made by non-residents. The Amendments include a withholding tax on distributions made to non-residents from gains realized on taxable Canadian property ( TCP ) 1 and other similar property, and a new distribution tax of 15% on otherwise non-taxable distributions made by royalty funds and REITs to non-residents. The proposal to hard wire the restriction on non-resident ownership of mutual funds at a 50% threshold, with no relieving provision where there has been a temporary surge in non-resident investment, has been suspended pending further discussions. These Amendments represent a significant expansion in Canada s approach to source taxation, particularly in the case of the proposed distribution tax. Withholding Tax on TCP Gains Distributions One of the principal Budget Proposals was the introduction of a tax on distributions to non-residents made by mutual funds that are linked to gains realized on the disposition of TCP. The Amendments require both a mutual fund trust and a mutual fund corporation to maintain a dedicated account ( TCP gains balance account ) for recording gains from the disposition of TCP after March 22, The TCP gains balance account would include the total of capital gains realized from the disposition of properties that are TCP after March 22, 2004, and any TCP gains distributions from a mutual fund trust or dividends received from a mutual fund corporation at or before the end of the year. Capital losses from dispositions of TCP after March 22, 2004 and the total amount of TCP gains distributions designated to be received by beneficiaries (or the total amount of TCP gains distributions received by shareholders of a mutual fund corporation) are subtracted from the account. 2 The Amendments work in a similar fashion for both mutual fund corporations and mutual fund trusts. Both adopt the concept of a TCP gains balance and a TCP gains distribution. In the case of a mutual fund corporation, proposed subsection 131(5.1) of the Income Tax Act (the Tax Act ) 3 deems any amount that the corporation elects to treat as a capital gains dividend, to be instead an ordinary taxable dividend to the extent of the non-resident shareholder s pro rata share at that time of the corporation s TCP gains balance. 1 See Appendix A for a summary definition of taxable Canadian property. 2 Subsections 131(6) and 132(4) propose a definition of the TCP gains balance accounts for mutual fund corporations and mutual fund trusts, respectively. 3 References to a statute are references to the Tax Act unless stated otherwise. w BORDEN LADNER GERVAIS LLP

2 In the case of a mutual fund trust, proposed paragraph 132(5.1)(a) deems any amount that the trust designates as a capital gain payable to a beneficiary, to be a TCP gains distribution equal to the lesser of twice the amount designated and the beneficiary s pro-rata share of the trust s TCP gains balance for the taxation year. Where the beneficiary is a non-resident person (or a non-canadian partnership), proposed paragraph 132(5.1)(b), provides that any amount designated as a capital gain payable to such non-resident beneficiary, is only a capital gain to the extent that it exceeds one half the TCP gains distribution. Subsection 104(21) is made expressly subject to the new deeming rule in paragraph 132(5.1)(b). Consequently, that designated amount is included in income of the non-resident beneficiary under subsection 104(13) and becomes an amount to which withholding tax imposed by paragraph 212(1)(c) applies. As a result, the distribution is effectively treated as ordinary income, in the hands of a non-resident beneficiary, and will be subject to a 25% withholding tax unless the rate is reduced by an applicable tax treaty (in which case it will usually be 15%). There is a de minimis threshold such that the withholding tax is not applicable where the mutual fund trust or mutual fund corporation can establish that not more than 5% of the distributions or dividends are paid to nonresidents or non-canadian partnerships. It is uncertain what value this provision will have unless the mutual fund can ensure that it never goes offside the 5% threshold. Furthermore, if the 5% threshold is exceeded in any year, the mutual fund will have to reconstruct its TCP gains balance account from historical information. Capital Distributions From Canadian Resource and Real Estate Trusts The second tax proposal directed at non-resident investment in income trusts is the imposition of a flat 15% tax on assessable distributions made by certain resource and real estate based income trusts. Proposed section adds a new Part XIII.2 to the Tax Act. An assessable distribution is defined as an amount that is paid or credited by a mutual fund that is a Canadian property mutual fund investment to a non-resident provided that such payment is NOT otherwise subject to tax under Part I or Part XIII. This definition will typically apply to returns of capital. If a broad interpretation of this charging provision is applied, then the investment strategy of the mutual fund must be carefully considered to avoid creating an additional and unnecessary withholding tax cost on distributions. For the purpose of this note, we will assume that an assessable distribution is generally a return of capital. The proposed tax on capital distributions is applicable only to an assessable distribution in respect of a Canadian property mutual fund investment. A Canadian property mutual fund investment is a unit of a mutual fund trust or a share of a mutual fund corporation that: (a) is listed on a prescribed stock exchange, and (b) more than one-half of the fair market value of all its property is attributable to either real property situated in Canada, a Canadian resource property or a Canadian timber resource property. 4 The words attributable to are very broad and would presumably apply to any investment in a Canadian mutual fund where the value of that investment is causally connected to Canadian real property, a Canadian resource property or a timber resource property ( Canadian property ). For example, an investment in a closed end fund whose principle investment strategy is the purchase of securities of REITs or royalty funds could be considered a Canadian property mutual fund investment if more than 50% of the value of such securities are attributable to 4 See Appendix A for a summary definition of Canadian resource property. 2 BORDEN LADNER GERVAIS LLP

3 underlying Canadian property. A second potential example are securities of business income trusts which have significant real estate assets on their balance sheet. Although the definition of Canadian property mutual fund investment has a 50% or more test, that threshold could become uncomfortably tight where an index type fund holds a meaningful investment in REITs and/or royalty funds and the business trusts in which it has invested, have significant real estate assets on their balance sheet. That investment fund may then need to bifurcate its investment strategy into two separate entities and incur extra administrative costs in order to safeguard against the proposed Part XIII.2 tax. Where there is an assessable distribution made on a Canadian property mutual fund investment the amount of the tax is equal to 15% of the distribution, which is treated as a capital gain that the non-resident is deemed to have received from the disposition of property. The amount of the assessable distribution is not deducted from the non-resident's adjusted cost base ( ACB ) in the mutual fund trust (as would normally be the case with returns of capital). The proceeds of disposition are equal to the amount of the assessable distribution, and the ACB in respect of this notional property is deemed to be NIL. This tax is required to be deducted and remitted by the payor. The non-resident is not, however, required to file a tax return in respect of this notional disposition, other than in the situation described below. Proposed subsection 218.3(3) allows the non-resident to file a special return to offset any capital loss realized on the disposition of an investment on or before the filing due date for a taxation year. The capital loss, if any, cannot exceed the assessable distributions previously subject to the 15% tax. A loss realized on an investment can be carried back three years and carried forward indefinitely by non-residents against other Canadian property mutual fund investments. Non-Resident Ownership Restrictions This tax proposal, as included in the September 16, 2004 draft legislation, would have caused a trust to permanently lose its status as a mutual fund trust if at any time more than 50% of its units were held by nonresidents. The proposal has been suspended, pending further review. It was never clear why this proposal was needed to address the tax leakage issue or why it represented an improvement over the current version of subsection 132(7), other than the expansion of restricted property to include both TCP and similar property. Moreover, it would have been extraordinarily difficult for mutual funds to monitor ownership levels given that National Instrument allows an investor to set up a screen that will prevent a mutual fund from knowing anything about an investor, including his or her place of residence. In any event, this tax proposal is now officially sidelined pending further discussion. Suspended Loss Rules The Amendments also propose a partial legislative fix for the suspended loss issue, which could arise because mutual fund groups often had common trustees and each trust was therefore potentially an affiliated person. The amendments create a set of rules to determine when a trust is affiliated with another trust and/or its contributors by reference to a person who is a majority interest beneficiary of the trust. The general rule introduced by the legislation is that two trusts will not be affiliated only because they share a majority interest beneficiary or because they share the same trustee. These particular amendments are generally effective at any time after March 22, BORDEN LADNER GERVAIS LLP 3

4 APPENDIX A Taxable Canadian Property as defined in subsection 248(1) includes any property of the taxpayer that is 5 1. Real property situated in Canada. 2. Property used by the taxpayer in a business carried on in Canada, including eligible capital property and inventory, other than property used as part of an insurance business or an international transportation business. 3. Unlisted shares of a corporation resident in Canada (other than a mutual fund corporation) Listed shares of a corporation resident in Canada, if at least 25% of the shares were owned by the nonresident taxpayer and any persons with whom the non-resident did not deal at arm s length at any time during the preceding 60 months. 5. Unlisted shares of a non-resident corporation where at any time in the preceding 60 months, (i) more than 50% of the fair market value of all its properties was represented by any combination of TCP, Canadian resource property, timber resource property, an income interest in a Canadian trust or an option or interest in any of the latter three types of properties, ( Canadian source properties ), and (ii) more than 50% of the fair market value of such shares was derived directly or indirectly from any one or any combination of real property situated in Canada, Canadian resource properties or timber resource properties Listed shares of a non-resident corporation provided that (i) the requirements in paragraph five (above) are satisfied (except for the fact that the shares are not unlisted) and (ii) at least 25% of the shares any class of the corporation were owned by the non-resident taxpayer and persons with whom the taxpayer did not deal at arm s length at any time during the preceding 60 months. 7. An interest in a partnership if at any time in the preceding 60 months, more than 50% of the fair market value of all its properties was represented by Canadian source properties. 8. A capital interest in a trust resident in Canada (other than a unit trust). 9. A unit of a unit trust (other than a mutual fund trust). 5 This is not intended to be an exhaustive list. 6 Unlisted shares include both shares of private companies, and shares of public companies which are not listed on a prescribed exchange. 7 This valuation is made on a net basis, which means that the value of underlying property is netted against its identified and traceable liabilities. In contrast, the first part of the test seems to look only at the gross value of Canadian source properties compared to the gross value of non-canadian source properties assets held by the corporation, without taking into account associated liabilities. 4 BORDEN LADNER GERVAIS LLP

5 10. A unit of a mutual fund trust, if at any time in the preceding 60 month period, the non-resident taxpayer (or persons not dealing at arm s length with the taxpayer) owned 25% or more of the issued units. 11. An interest in a non-resident trust, where at any time, the preceding 60 month period, (i) more than 50% of all its properties consisted of Canadian source properties, and (ii) more than 50% of the fair market value of those shares was derived directly or indirectly from any one or any combination of real property situated in Canada, Canadian resource properties or timber resource properties. 12. An interest or option in respect of any of the above properties A Canadian resource property. 14. A timber resource property. 15. An income interest in a trust resident in Canada. Canadian resource property of as defined in subsection 66(15) means any property of the taxpayer that is 1. Any right, license or privilege to explore for, drill for or take petroleum, natural gas or related hydrocarbons in Canada. 2. Any right, license or privilege to (i) store underground petroleum, natural gas or related hydrocarbons in Canada; or (ii) prospect, explore, drill or mine for minerals in a mineral resource in Canada 3. Any oil or gas well in Canada or any real property in Canada the principal value of which depends on its petroleum or natural gas content (but not including any depreciable property). 4. Any right to a rental or royalty computed by reference to the amount or value of production from an oil or a gas well in Canada, or from a natural accumulation of petroleum or natural gas in Canada, if the payer of the rental or royalty has an interest in the well or accumulation, as the case may be, and 90% or more of the rental or royalty is payable out of, or from the proceeds of, the production from the well or accumulation. 5. Any right to a rental or royalty computed by reference to the amount or value of production from a mineral resource in Canada, if the payer of the rental or royalty has an interest in the mineral resource and 90% or more of the rental or royalty is payable out of, or from the proceeds of, the production from the mineral resource. 8 An option or interest in real property could include for example, a mortgage which grants participation in any appreciation of real property secured by the mortgage. BORDEN LADNER GERVAIS LLP 5

6 6. Any real property in Canada the principal value of which depends on its mineral resource content (but not including any depreciable property). 7. Any right to an interest in any property described above in paragraphs (1) to (6) other than a right or interest as a beneficiary under a trust or as a member of a partnership. Stephen J. Fyfe Borden Ladner Gervais LLP Lawyers Patent & Trade-mark Agents For further information, do not hesitate to contact one of the following members of our Tax Group: Calgary 1000 Canterra Tower 400 Third Avenue S.W. Calgary, Alberta T2P 4H2 Tel.: (403) Fax: (403) Stephen J. Fyfe Tel: (416) sfyfe@blgcanada.com Stephanie Wong Tel: (416) swong@blgcanada.com Craig J. Webster Tel: (416) cwebster@blgcanada.com Francesco Gucciardo Tel: (416) fgucciardo@blgcanada.com Montréal 1000 de La Gauchetière Street W. Suite 900 Montréal, Québec H3B 5H4 Tel.: (514) Fax: (514) Ottawa World Exchange Plaza 100 Queen Street Suite 1100 Ottawa, Ontario K1P 1J9 Tel.: (613) Legal Fax: (613) IP Fax: (613) Toronto Scotia Plaza, 40 King St. W. Toronto, Ontario M5H 3Y4 Tel.: (416) Fax: (416) Vancouver 1200 Waterfront Centre 200 Burrard Street P.O. Box Vancouver, British Columbia V7X 1T2 Tel.: (604) Fax: (604) This newsletter is prepared as a service for our clients and other persons dealing with finance and investment issues. It is not intended to be a complete statement of the law or an opinion on any subject. Although we endeavour to ensure its accuracy, no one should act upon it without a thorough examination of the law after the facts of a specific situation are considered. No part of this publication may be reproduced without prior written permission of Borden Ladner Gervais LLP. This newsletter has been sent to you courtesy of Borden Ladner Gervais LLP. We respect your privacy, and wish to point out that our privacy policy relative to newsletters may be found at If you have received this newsletter in error, or if you do not wish to receive further newsletters, you may ask to have your contact information removed from our mailing lists by phoning BLG-LAW1 or by ing subscriptions@blgcanada.com Borden Ladner Gervais LLP 6 BORDEN LADNER GERVAIS LLP Waterloo Region 508 Riverbend Drive, Suite 303 Kitchener, Ontario, N2K 3S2 Tel.: (519) Fax: (519) Borden Ladner Gervais LLP is an Ontario Limited Liability Partnership