In this troubled, chaotic world we are living in, Canada remains a politically and financially stable locale that is an attractive destination for foreign investment.
I have little doubt that, in the years ahead, investment in Canadian real estate by non-residents will continue to be quite substantial.
Over the years, I have found that most Canadian advisors seem to be rather oblivious to one basic fact: Under the right circumstances, ownership of Canadian real estate by a non-resident corporation (“Forco”) can result in the lowest potential liability, for Canadian taxes on any resulting capital gain, of any of the potential forms of ownership.
I will explain what I mean by “Under the right circumstances” below, but let’s look at the tax rate that would be applied in such cases to Forco on the capital gain.
50% of the capital gain would be subject to Canadian tax. Forco would be subject to Canadian federal tax (no provincial tax) at a rate of 25%, so the effective tax rate would be 12.5%. Not too bad!
Let’s compare to the two other common alternatives: ownership by an individual, and Canadian corporate ownership.
First let’s look at individual ownership (by a natural person). If we are talking big money, let’s assume that virtually all of the taxable gain would be taxed at the highest marginal rate. For a non-resident, that is 48.84%[1]. That means an effective rate of 24.42% on the capital gain. (For a trust, the same rate would apply).
What about a Canadian corporation (“Canco”). The rate would be 15% federal tax plus the applicable provincial tax. Let’s take Ontario as the most likely locale-that equates to a combined rate of 26.5%, giving an effective tax rate of 13.25%. Not much more than the Forco rate, but there is a catch: there will be an additional tax when Canco distributes its after-tax profits to its non-resident shareholder as an actual or deemed dividend. This tax is levied under Part XIII of the Income Tax Act (“the Act”) and will even apply to the “tax-free” 50% of the capital gain[2]. So, the remaining 86.75% will ultimately be subject to Part XIII tax. In the absence of a treaty, the rate would be 25%, which would increase the effective rate to 34.94%. Even if the lowest treaty rate of 5% applied[3], the effective rate would be 17.63%.
To recap:
Forco 12.5%
Individual 24.42%
Canco 17.63%-34.94%
Now, let’s get to the “Under the right circumstances” part!
The 12.5% rate for Forco assumes that there is no additional tax under Canada’s “branch profits tax” which is levied under Part XIV of the Act.
In the absence of a treaty applying, this can equate to 25% of the amount by which the capital gain exceeds the regular corporate income taxes.
The tax under Part XIV of the Act will only apply if the real estate is held in the course of a business carried on in Canada[4]. Hence, the key is to avoid that.
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The most obvious situation where Part XIV tax should not apply would be where the real estate is personal use property that is held for the benefit of Forco’s shareholder or a member of his/her family-no business there!
But, what about situations where the real estate is held by Forco to earn income? Avoiding business treatment in such situations is admittedly difficult because there appears to be a general (albeit rebuttable) presumption in Canadian tax law that corporate activities, including the earning of rental income in relatively passive situations, represent the carrying on of a business[5].
However, the CRA does acknowledge that, in certain very passive situations, rental income earned by a corporation just represents income from property, and not a business[6].
In particular, the CRA indicates in paragraph 7 of Interpretation Bulletin IT-177R2 and paragraph 13 of Interpretation Bulletin IT-420R3 that real estate rental income derived by a non-resident corporation would normally constitute income from a business, except where such real estate is “rented under a long-term lease to a single tenant with limited landlord responsibilities”.
Now, at first blush, this may suggest that Forco can only avoid Part XIV tax in very rare circumstances.
However, I suggest that the situations are actually unlimited.
That is, even if fairly active operations are contemplated, Forco can still be the owner of the real estate and lease it, under terms as outlined above, to another related entity (such as a Canadian corporation) that would carry out the operations. The trick is to separate the ownership of the real estate from the operations with the outside world.
[1] 33% highest marginal rate, plus 48% additional tax-1.48 x 33%
[2] Unlike the situation with amounts paid to Canadian residents, dividends paid to non-residents from a corporation’s “capital dividend account” are taxable (under Part XIII of the Act).
[3] Which would only be the case if a treaty-resident corporation was the shareholder of Canco.
[4] If not, the capital gain is effectively excluded from Part XIV tax by virtue of subsection 219(1.1) of the Act-this is consistent with the calculation of Part XIV tax as shown on the CRA’s T2SCH(20).
[5] See, for example, the decision of the Supreme Court of Canada in Canadian Marconi Co. v. The Queen, 86 DTC 6521. However, the decision of the Tax Court of Canada in Matlas S.A. v. The Queen, 94 DTC 1561 held that, notwithstanding that general presumption, in that particular situation, the real estate rental activity did not constitute a business due to its passive nature.
[6] Normally, in such circumstances, Forco would file a corporate tax return in Canada on the basis of electing under section 216 of the Act to be taxed on net income, as opposed to a situation where it is carrying on business in Canada. At one time, if the real estate was in Ontario, there was a form of double tax, in such situations, because no 10% abatement was allowed for federal purposes, even though Ontario levied corporate income tax. However, with the “harmonization” of federal and Ontario corporate income taxes some years ago, this is no longer an issue.
ABOUT THE AUTHOR OF THIS ARTICLE
Michael I. Atlas, CPA,CA,CPA(ILL),TEP
Michael Atlas is one of the most prominent international tax experts in Canada. He advises accounting and law firms all across Canada, as well as select private clients (corporate and personal) worldwide. He can be reached by phone (416.860.9175) or email (matlas@TaxCA.com).
