Income Tax Implications for Non-Residents Investing in Canadian Real Estate

General

For a number of reasons, non-resident investors have been a major factor in many facets of the Canadian real estate marketplace for many years.

Like most major countries, Canada taxes non-residents on income earned from the rental of real estate within its borders, as well as on gains realized on the sale of such real estate. In general, Canada's tax treaties allow it unrestricted right to tax such income in the hands of non-residents.

Rental Income

The Canadian taxation of real estate rental income earned by a non-resident will vary depending on whether or not the rental activities are considered to be a business. In the case of rental income earned by an individual (which will include a natural person as well as a trust or estate) rental activities will not normally be considered to constitute a business unless services are provided that go beyond those normally associated with a rental activity. On that basis, the ownership and operation of an apartment building by a non-resident individual will not normally be considered a business; whereas the ownership and operation of a hotel will.

In the case of a corporation, there is a general presumption in Canadian tax law that all activities of a corporation constitute a business. In the case of rental activities, an exception might be the rental of real estate to a single tenant under a "net/net" lease.

Under the assumption that the rental activities do not constitute a business, a non-resident in receipt of rental income derived from real property situated in Canada will have the option of paying Canadian tax under two methods:

• The gross rents method, or
• The net income method

This choice must be made from year to year, and there is no prohibition on switching the method used from one year to another. 

Gross Rents Method

Under this method, the tax paid (under Part XIII of the Income Tax Act-"the Act") is equal to 25% of the gross rents. For this purpose, based upon a famous Supreme Court of Canada decision in 1968, it would appear that gross rents must include property taxes paid directly by the tenant to the municipality.

This 25% rate is not reduced under the latest versions of any of Canada's tax treaties.

No Canadian tax return need be filed under this method, and tax should be withheld and remitted by the tenant or agent.

It should be understood that, in the absence of a timely filing of a Canadian tax return under section 216 of the Act (as discussed below) the non-resident would be required to pay tax using the gross rents method. This will be the case even if there is no net income after expenses are deducted.

Net Income Method (Section 216)

In lieu of paying Canadian tax on gross rents under Part XIII, a non-resident may elect, instead, to pay tax under Part I of the Act, on the net income. In the case of natural persons and estates, tax will be calculated using graduated tax rates similar to those that apply to Canadian residents. Provincial income taxes will generally not be payable for such individual; however, in lieu thereof a special federal surtax will apply. The end result, based on 2004 rates, is that a combined tax rate of 23.68% will apply to income up to $35,000. However, the rate increases to a point where the marginal tax rate is 42.92% on income over $113.804.

In the case of corporations, federal taxes at a rate of 32.12% will apply regardless of the level of taxable income.

In the case of corporations earning non-business rental income in Ontario, Ontario corporation income taxes (at a rate of 14%) will also apply to the net income (regardless of which of the two methods are used for federal purposes). Notwithstanding that fact, the 10% "provincial abatement" normally provided by the federal government will not apply.

As a general rule, a Canadian tax return must be filed within 2 years from the end of the relevant year to use this method.

However, if a form NR6 (undertaking to file a Canadian tax return) is filed in order to reduce tax withheld at source, the return must be filed within 6 months from the end of the relevant year to use this method.

Rental losses may not be carried over to other years on a section 216 return.

Rental Activities that Constitute a Business

In cases where the rental activities constitute a business carried on in Canada, the non-resident will be required to pay tax on the net income derived from such activities under Part I of the Act. The gross rents method will not be available.

In such situations, there is no requirement for withholding tax to be remitted to the taxation authorities.

In the case of non-resident individuals, provincial income taxes will be payable instead of the federal surtax that normally applies where a return is filed under section 216 of the Act.

Corporate taxes at a federal rate of 22.12% will apply where the non-resident is a corporation. In addition, corporation taxes will be payable to the province in which the real estate is located-in Ontario the rate is 14%. Furthermore, "branch profits tax" under Part XIV of the Act will also apply. In general terms, this tax is equal to 25% of the profits earned each year after deducting normal federal and provincial income taxes as well as an "investment allowance" relating to the cost of assets remaining in the business in Canada. If the corporation is resident in a country with which Canada has a tax treaty, the 25% rate will usually be reduced (to as low as 5%) and some exemption may be available.

Furthermore, in situations where the rental activities constitute a business, resulting losses may generally be carried back for up to 3 years and forward for up to 7 years (to be increased to 10 under proposed amendments).

Gains from Sale

Canada taxes non-residents on taxable capital gains arising from the sale (or other "disposition") of "taxable Canadian property" ("TCP").

Since interests in real estate situated in Canada are included in the TCP definition, non-residents who realize taxable capital gains from the disposition of real estate will be subject to Canadian tax.

In general terms, the amount of the "taxable capital gain" is equal to 50% of the amount by which the "proceeds of disposition" (e.g. sale price) exceeds the total of the "adjusted cost base" of the property plus costs entailed in making the disposition (e.g. real estate commissions).

The resulting taxable capital gain is included in computing income and subject to tax at the relevant tax rate. Since only 50% of capital gains are included in income, the effective tax rate is generally half the normal rate on income.

In certain cases, a gain from the sale of real estate may be fully taxable business income, rather than a capital gain. This will be the case, for example, where the taxpayer is engaged in a business of developing real estate for sale. It will also be the case even if the real estate was acquired as part of an isolated speculative transaction in order to resell it at a profit (an "adventure or concern in the nature of trade").

In cases where a portion of the sale price is not yet due at the end of the year of sale, Canadian tax law normally allows a "reserve" to be claimed under which the recognition of an appropriate portion of the taxable capital gains is deferred. However, the claiming of such a reserve is not permitted where the taxpayer in question is a non-resident.

None of Canada's tax treaties preclude it from levying tax on gains from the disposition of Canadian real estate. However, Canada's treaties with the United States and the Netherlands contain "fresh start" rules under which gains accrued prior to certain dates in the 1980s will be exempt from Canadian tax.

Indirect Interests

In certain cases, indirect interests in Canadian real estate (i.e. interests held through corporations, partnerships, or trusts) may also constitute TCP. As such, capital gains realized by non-residents on the disposition of their interests in such entities will be subject to Canadian tax under the Act.

For example, shares in corporations resident in Canada will always be TCP unless they are listed on a prescribed stock exchange. Even shares of non-resident corporations will be TCP if most of the underlying value is attributable to Canadian real estate.

However, under the provisions of many of Canadian tax treaties, Canada will be precluded from taxing gains realized by residents of the relevant jurisdiction on certain types of TCP. For example, under Canada's tax treaty with the United States, Canada would generally be precluded from taxing U.S. residents on capital gains from the disposition of shares of corporations not resident in Canada, even if most of the value of such shares is attributable to underlying Canadian real estate. In addition, in certain cases (e.g. Canada's tax treaty withBarbados) gains from the disposition of shares in real estate holding corporation may only be taxed if the Canadian real estate is directly held by that corporation-if it is held by a subsidiary of that corporation, Canada may not tax the gain. In addition, under certain treaties (e.g. Canada's tax treaty with the United Kingdom), Canada may not tax gains from the disposition of shares in corporation if the underlying value is mainly attributable to real estate used in a business (other than a rental business) of that corporation.

Tax Clearance Requirements and Withholding

In the absence of obtaining a tax clearance from the Canada Revenue Agency, a person acquiring TCP from a non-resident is obliged to remit amounts on account of that non-resident's tax. In certain cases, an additional requirement will apply in connection with Quebectaxation authorities where the property is real estate situated in the Province of Quebec.

As a general rule, the amount of tax that must be remitted in the absence of a tax clearance is 25% of the purchase price. However, where the property is "depreciable property" (e.g. the building component of the real estate) or real estate inventory, the rate is 50%.

In order to obtain a clearance, the vendor must pay or post security for 25% of the amount by which the sale price exceeds the adjusted cost base of the property. Furthermore, where "capital cost allowance" (i.e. the Canadian tax equivalent of depreciation) has been claimed additional amounts may be required. Normally, the amount paid or posted exceeds the actual tax liability that will be calculated when the tax return is filed. This is because of the fact that the rate of tax generally exceeds the actual effective tax rate, as well as the fact that "costs of disposition" (e.g. sales commissions) may not be deducted in computing the amount required to obtain the clearance, whereas they are allowed in computing the capital gain when the return is filed.

Deemed Disposition on Death

In cases where a non-resident holds an interest in Canadian real estate (or other TCP) at the time of his or her death, he or she will be deemed to have disposed of such TCP immediately before that time for proceeds of disposition equal to the fair market value of such property.

Unlike the situation where a Canadian resident dies, there will generally be no "spousal rollover" (i.e. deferral of capital gains where property passes to a spouse) allowed on the death of a non-resident. However, if the non-resident is a U.S. resident, the spousal rollover may be available as a result of a special provision found in the Canada-U.S. Tax Convention.

In certain cases, proper planning may avoid exposure to the Canadian taxation of capital gains on death. For example, if the non-resident holds his or her interest by means of an entity that is not TCP (e.g. a partnership in which interests in TCP represent a minority of the value of its assets) Canadian tax liability may be avoided. Other strategies might depend on the application of the tax treaty betweenCanada and the non-resident's country of residence to the nature of the entity through which the real estate is held.