Principal Issues: Taxation of distributions from a Canadian mutual fund trust to U.S. IRA trust.
Position: Depending on the facts, may be subject to 15% withholding.
Reasons: Existing paragraph 212(1)(c) or new subsection 132(5.1) apply withholding of 25%, reduced to 15% by Article XXII of the Canada-U.S. Income Tax Convention. New section 218.3 withholding of 15%, no relief under the Convention.
XXXXXXXXXX 2006-018746 S. E. Thomson August 23, 2006
Dear XXXXXXXXXX:
Re: XXXXXXXXXX / Royalty & Income Trusts
This is in reply to your fax of May 19, 2006, in which you ask for our viewpoints regarding two letters received by XXXXXXXXXX.
XXXXXXXXXX
XXXXXXXXXX was assessed penalty and interest for not filing a return of income as required under the Income Tax Act (the "Act") for the XXXXXXXXXX taxation year. XXXXXXXXXX would like XXXXXXXXXX the penalties and interested waived. Further, XXXXXXXXXX would like XXXXXXXXXX assistance in amending Article XVI of the Canada-U.S. Income Tax Convention (the "Convention") so that XXXXXXXXXX are subject to paragraph 3 of Article XVI.
We have forwarded a copy of XXXXXXXXXX letter to Mara Praulins, Director of the International Tax Operations Division, and asked her to respond to you regarding the penalties and interest assessed to XXXXXXXXXX. With regard to modifications to the Convention, we suggest that you contact the U.S. Treasury. We have forwarded to you by email the names of two officials of the U.S. Treasury who are currently involved in negotiations of the 5th protocol to the Convention.
Royalty / Income Trusts
The second letter is from XXXXXXXXXX, a U.S. resident, to XXXXXXXXXX. The facts in the letter are not entirely clear, but it appears that XXXXXXXXXX has an IRA trust that is receiving distributions from a Canadian mutual fund trust. He states that in 2004, distributions from the mutual fund trust became subject to a 15% withholding tax in Canada. He notes that "dividends" paid to an IRA should be exempt from withholding tax under the Convention, and he feels that Canada is no longer honouring its obligations under the Convention.
a) Dividends & Interest
XXXXXXXXXX correctly notes that dividends paid to an IRA are exempt from withholding tax in Canada. Specifically, paragraph 2 of Article XXI (Exempt Organizations) of the Convention provides:
Subject to the provisions of paragraph 3, income referred to in Articles X (Dividends) and XI (Interest) derived by:
(a) a trust, company, organization or other arrangement that is a resident of a Contracting State, generally exempt from income taxation in a taxable year in that State and operated exclusively to administer or provide pension, retirement or employee benefits; or
(b) a trust, company, organization or other arrangement that is a resident of a Contracting State, generally exempt from income taxation in a taxable year in that State and operated exclusively to earn income for the benefit of an organization referred to in subparagraph (a);
shall be exempt from income taxation in that taxable year in the other Contracting State.
However, XXXXXXXXXX IRA is receiving distributions from a trust, which is not the same as receiving payments of dividends or interest.
b) Distributions From a Mutual Fund Trust
Distributions of income (such as dividends and interest) from a Canadian resident trust to a non-resident beneficiary are subject to a 25% withholding by virtue of paragraph 212(1)(c) of the Act, reduced to 15% when paid to a resident of the U.S. by virtue of Article XXII of the Convention.
However, until recently, distributions of taxable capital gains or distributions of capital from a Canadian mutual fund trust to a non-resident beneficiary were not taxable under the Act. In the 2004 Federal Budget, the Government of Canada outlined its intention to amend the Act to apply a withholding tax to certain distributions paid by a Canadian mutual fund trust to a non-resident beneficiary. The withholding tax will apply in either of the two following situations:
1. If a Canadian mutual fund trust disposes of taxable Canadian property, and distributes the taxable capital gain to a non-resident after March 22, 2004, subsection 132(5.1) of the Act will apply, but only if more than 5% of the amounts designated are designated to non-residents or partnerships that are not Canadian partnerships. If subsection 132(5.1) applies, the payer must withhold 25% of the distribution. The withholding rate is reduced to 15% under the Convention.
2. If a Canadian mutual fund trust makes a distribution to a non-resident person or partnership other than a Canadian partnership after 2004, the mutual fund unit is listed on a prescribed stock exchange, and more than 50% of the fair market value of the mutual fund unit is attributable to real property in Canada, Canadian resource property or timber resource property, section 218.3 of the Act will apply, unless the distribution is already subject to tax under Part I or Part XIII of the Act. The terms "Canadian resource property" and "timber resource property" are defined in the Act. If section 218.3 applies, the distribution is deemed to be a disposition of taxable Canadian property, and the payer must withhold 15% of the distribution, with no relief under the Convention.
However, if the non-resident investor realizes a capital loss on the actual disposition of the mutual fund investment in the year or in any of the three subsequent taxation years, the non-resident investor may file a Canadian income tax return and claim a refund of some or all of the tax paid under section 218.3.
For more information, see Annex 9 to the March 23, 2004 Budget Plan, under the heading "Income Trusts". Annex 9 can be viewed at the following website:
http://www.fin.gc.ca/budget04/bp/bpa9ae.htm#IncomeTax
Concerns regarding this new legislation should be addressed to:
Department of Finance, Canada
Tax Policy Branch
17th Floor, East Tower
140 O'Connor Street
Ottawa, Ontario
K1A 0G5
We trust that we have been of some assistance.
Yours truly,
Sherry Thomson, Acting Manager
For Director
International & Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch