By Anthony Diosdi
Canadians actively invest in U.S. real estate by speculating on land and developing homes, condominiums, shopping centers, and commercial buildings. Canadian investors generally have the same goals of minimizing their income tax liabilities from their U.S. real estate investment as do their U.S. counterparts. Although their objectives are complicated by the very fact that they are not U.S. persons. That is, Canadian investors must be concerned not only with income taxes in the United States, but also Canadian taxes. Further, the United States has special income tax regimes that are applicable to foreign persons. This article attempts to summarize the cross-border consequences surrounding a Canadian’s acquisition of different U.S. real property interests.
Holding U.S. Real Estate Directly
The simplest way for a Canadian investor to acquire U.S. real estate is to purchase it outright. Although holding U.S. real property outright is easy to understand, there are a number of complications associated with holding rental property outright. If a Canadian investor owns real property that is income producing, he or she will likely be required to file tax returns in Canada and the United States reporting the U.S. rental income. The income tax consequences of the U.S. rental income would be determined under both Canadian and U.S. tax laws, and the investor would pay the higher of the U.S. or Canadian income tax. There are also differences in compliance rules to consider. For example, the U.S. rules relating to depreciation, interest deductions, and foreign exchange gains differ from the Canadian rules.
A Canadian investor in income producing property must understand U.S. source income received by foreign persons are subject to two basic taxing regimes. First, if a Canadian investor derives certain types of passive income from a U.S. source, it is typically taxed at a flat 30 percent rate (without allowance for deductions), unless the U.S.-Canada tax treaty reduces this statutory rate. Items of income that are effectively connected with a U.S. trade or business will be taxed effectively connected income and subject to graduated rates. The Canadian investor must determine whether the ownership and operation of the real property should be viewed as a U.S. trade or business or not. This decision will likely have a significant impact on the amount of U.S. taxes the investors pays.
For example, if a Canadian investor intends to lease U.S. real estate and if that activity does not give rise to a U.S. trade or business, the rental income derived from the property is subject to U.S. withholding tax at the rate of 30 percent (unless an election is made under Section 871(d) or 882(d) of the Internal Revenue Code). This withholding rate is not reduced under the United States-Canada Income Tax Treaty. The withholding tax is based on gross rental income and would include real estate taxes paid directly by a tenant.
Besides the U.S. income tax consequences associated with holding U.S. real property, Canadian investors must understand the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”). The FIRPTA tax regime was designed to ensure that foreign investors are taxed on the disposition of U.S. real estate. FIRPTA provides that a purchaser of a U.S. real property interest from a non-U.S. person is, in general, required to withhold 15 percent of the purchase price. This amount can be claimed against any U.S. tax associated with the disposition of the real property. In some cases, a Canadian investor can apply to the Internal Revenue Service (“IRS”) for a certificate authorizing a reduction or elimination of the withholding tax.
If, in lieu of a sale, a Canadian investor transfers U.S. real estate by will or by gift, U.S. estate and gift tax may be implicated. The United States imposes estate and gift taxes on certain transfers of U.S. situs property by “nonresident citizens of the United States.” In other words, individual foreign investors may be subject to the U.S. estate and gift tax on their investments in the United States. The U.S. estate and gift tax is assessed at a rate of 18 to 40 percent of the value of an estate or donative transfer. An individual foreign investor’s U.S. taxable estate or donative transfer is subject to the same estate tax rates and gift tax rates applicable to U.S. citizens or residents, but with a substantially lower unified credit. The current unified credit for individual foreign investors or nonresident aliens is equivalent to a $60,000 exemption, unless an applicable treaty allows a greater credit. U.S. citizens and resident individuals are provided with a far more generous unified credit from the estate and gift tax. U.S. citizens and resident individuals are permitted a unified credit of $12,920,000 or $25,840,000 for a married couple (for the 2023 calendar year).
Article XXIX(B) of the U.S.-Canada tax treaty provides relief from the U.S. estate tax. Under the treaty, a Canadian real estate investor is entitled to relief from the U.S. estate tax, but the treaty does not provide any relief from the U.S. gift tax. A Canadian investor can claim a pro rata portion of the U.S. unified credit and marital credit for estate tax purposes. The pro rata portion is based on the percentage of the individual’s gross U.S. estate and gross worldwide estate.
On November 9, 1995, the 1995 Canada Protocol was enacted as part of the U.S.-Canada income tax treaty. This protocol greatly impacts U.S. estate tax planning for Candians investing in the United States. Certain Canadian investors are able to enjoy an estate tax marital deduction and own a greater number of U.S. assets directly without incurring U.S. estate taxes. These Canada Protocol provisions may be summarized through the following points and illustrations:
Point 1. Canadian residents are not subject to U.S. estate tax unless their gross worldwide estate exceeds $10 million (for 2018 calendar year). Below, please see Illustration 1. Which demonstrates Point 1. (All dollar amounts contained in these illustrations are in U.S. dollars.)
Justin Lieber owns a vacation home in Florida with a value of $5,000,000, unencumbered by a mortgage. His other worldwide assets amount to $5,000,000. There will be no U.S. estate tax whether or not Justin Lieber is survived by his spouse.
Point 2. A Canadian citizen who passes away owning U.S. assets is entitled to a credit against his U.S. estate tax liability in an amount equal to that proportion of the U.S. unified credit as his U.S. situated estate bears to his worldwide estate. Below, please see Illustration 2. which demonstrates Point 2.
Bryan Bosling, a Canadian resident, owns two vacation homes in California and Hawaii, each of which is unencumbered by a mortgage and has a value of $5,450,000. Bryan also owns Canadian property with a total value of $10,900,000. When Bryan dies in 2018, his estate, for U.S. estate tax purposes, would be entitled to a prorated unified credit of $2,208,900 (i.e., $4,417,800 × ($10,900,000 / $21,800,000)). When applied against his computed gross U.S. estate tax of $4,305,800, this prorated unified credit results in a net U.S. estate tax liability of $2,096,900 (i.e., $4,305,800 – $2,208,900). If Bryan Bosling has a Canadian spouse and leaves property to her outside of a qualified domestic trust (QDOT), the U.S. will allow an election to be made for an additional nonrefundable marital credit up to the amount of the proportionate credit. The purpose of this limited marital credit was to alleviate, in appropriate cases, the impact of the estate tax marital deduction restrictions enacted by the Congress in the Technical and Miscellaneous Act of 1988 (“TAMRA”). The U.S. negotiators believed that it was appropriate, in the context of the 1995 Canada Protocol, to ease the impact of those TAMRA provisions upon certain estates of limited value.
Below, please find Illustration 3, which demonstrates the marital deduction under the U.S.-Canada treaty.
The facts are the same as in Illustration 2, except that Bryan Bosling leaves one of his two vacation homes in the U.S. to his Canadian spouse. The additional marital deduction “credit” allowed under the U.S.-Canada treaty equals the excess of the computed gross U.S. estate tax over the estate tax computed without including the U.S. property passing to the Canadian spouse. The marital deduction credit is capped at the estate’s prorated unified credit. Here, the U.S. estate tax on the vacation home not passing to Bryan’s spouse is $2,125,800. Thus, the marital deduction credit equals $2,180,000 (i.e., $4,305,800 – $2,125,800). After taking into account both the prorated unified credit and the marital deduction credit, the net U.S. estate tax liability owed by Bryan’s estate is reduced to zero (i.e., $4,305,800 – $2,208,900 – $2,180,000). Any excess marital deduction credit does not result in a refund.
Holding U.S. Real Property Through a Nongrantor Trust
A Canadian real estate investor may hold U.S. real estate in a nongrantor trust. If the U.S. activities of the trust rises to the level constituting a “U.S. trade or business” (as opposed to being merely a “passive investment”), then the trust is taxed largely in the same manner as a U.S. person (i.e., on the net income from the real estate trade or business, at graduated rates, albeit at compressed rates). The benefit of holding U.S. real property in trust is that the U.S. estate and gift tax may be avoided. Canadian investors may also avoid the U.S. branch profits tax (discussed below) utilizing a nongrantor trust to hold U.S. real estate.
Ownership of U.S. Real Property by a Canadian Company or Corporation
A Canadian investor may hold U.S. real estate through a Canadian company or corporation. For Canadian purposes, corporations are usually owned by multiple people, while companies can be owned by one individual. If a Canadian investor holds U.S. real property through a Canadian company or corporation, it would be required to file income tax returns in Canada and the United States, and a foreign tax credit for taxes paid to the U.S. may be available to reduce Canadian income tax liability. If a Canadian company carries on a U.S. trade or business or has effectively connected income, it will be required to file U.S. Under U.S. tax law, the classification of foreign business entities is made under a system that in many instances permits a foreign taxpayer to elect whether to have the business entity treated as a separate corporation or a fiscally transparent entity (i.e., treated, for U.S. tax purposes, as a partnership or disregarded as an entity separate from its owner). The largely elective nature of this determination under the current regulations has caused this classification system to be called the “check-the-box” entity classification rules. See Treas. Reg. Sections 301.7701-2, 3.
It should be emphasized, however, that not all business entities may elect their classification for U.S. tax purposes. Certain entities are treated as “per se” corporations for U.S. purposes. Certain entities are treated as “per se” corporations for U.S. tax purposes. The types of entities that are treated under the regulations as per se corporations include entities incorporated under state law incorporation statutes and certain foreign entities listed in the regulations. A Canadian corporation and Canadian company is considered a per se corporation for U.S. tax purposes. This means that a Canadian real estate investor that holds U.S. real estate through a Canadian company or Canadian corporation must report any U.S. taxable gains on a U.S. corporate tax return and pay U.S. corporate tax.
Holding U.S. real property in a Canadian holding company can trigger the U.S. branch profits tax. The branch profits tax equates to a tax equal to 30 percent of the corporation’s dividend equivalent amount for the taxable year, subject to treaty reductions. Internal Revenue Code Section 884 describes the tax base for the branch profits tax base as the “dividend equivalent amount,” which is defined as the “effectively connected earnings and profits” with certain adjustments. It is intended to be the functional equivalent of earnings distributed as dividends by a subsidiary either out of current earnings not invested in subsidiary assets or out of accumulated earnings withdrawn from such investment. The amount taxed is reduced, therefore, by any increase in the branch equity. Conversely, the amount of earnings taxed is increased by a reduction of branch equity but not in excess of effectively connected earnings and profits accumulated at the end of the prior tax year. Branch equity is measured by the adjusted basis of branch assets less liabilities connected with the branch. Article X of the U.S.-Canada income tax treaty reduces the branch profits tax to a rate of 5 percent on net income exceeding 500,000 Canadian dollars.
If a Canadian company is not carrying on a U.S. trade or business, it is subject to U.S. withholding tax at 30 percent of its income that is sourced in the United States, unless it makes a net election under the Internal Revenue Code to be taxed on net rental income as if the company were carrying on a trade or business or had effectively connected income.
A major decision in structuring a U.S. real estate investment concerns the manner in which the investment is financed. In general, interest on funds borrowed to acquire U.S. income-producing property is deductible in Canada. Section 20(1)(c) of the Canadian Tax Code provides that interest is deductible if it relates to the purchase of an interest in U.S. rental property, the acquisition of common stock in a U.S. company, or an investment in a U.S. partnership. As for the deductibility of interest payments for U.S. purposes, the Internal Revenue Code has intricate interest allocation rules and limitations on interest deductions.
Internal Revenue Code Section 163(j), as amended by the Tax Cuts and Jobs Act of 2017, can potentially apply to limit deductions for interest. The general rule of Internal Revenue Code Section 163(j) limits the deductibility of interest expenses paid or accrued on debt properly allocable to a trade or business to the sum of business interest income, and 30 percent of “adjusted taxable income.” Adjusted taxable income is determined without regard to certain deductions, including those for net interest expense, net operating loss carryforwards, depreciation, amortization, and deletion (“EBIT”). Any deduction in excess of the limitation is carried forward and may be used in a subsequent year, subject always to the limitations of Internal Revenue Code Section 163(j)(i.e., business interest income plus 30 percent of EBIT).
The general rule of Internal Revenue Code Section 163(j) is subject to two major exceptions: 1) the small business exception, and 2) the real property trade or business exception. The small business exception is met where the person meets the $25 million gross receipts test of Internal Revenue Code Section 448(c), which essentially looks at whether average annual gross receipts for the three tax year periods ending with the prior year exceeds $25 million. However, for purposes of applying these rules, certain aggregation rules will apply such that entities or persons that are “under common control” will be aggregated for the purpose of determining whether the $25 million threshold is met. The relevant tests to determine common control between entities generally looks for 50 percent minimum ownership threshold and/or whether five or fewer persons own more than 50 percent or two or more entities. See IRC Sections 58(a) and (b). Provided a timely election is made, the 30 percent limitation does not apply to a trade or business involving real property development, redevelopment, construction, reconstruction, rental, operation, acquisition, conversion, disposition, management, leasing or brokerage. If this election is made, depreciable real property held by the relevant trade or business must be depreciated under the alternative depreciation system under the Internal Revenue Code. This method is generally less favorable than the generally applicable system of depreciation contained in the Internal Revenue Code.
The differences in how Canada and the United States treat deductible interest income may result in the amount of interest that is deductible in the United States being different from the amount deductible in Canada.
A Canadian corporation and a Canadian company will be subject to U.S. and Canadian on gains realized on the sale of the U.S. real estate. Article XII of the U.S.-Canada income tax treaty confirms the United States’ right to tax gains derived from the sale of U.S. real estate. As discussed above, FIRPTA imposes withholding tax on the sale of the real estate. Any gain on the sale of the real estate is also subject to tax in Canada with a potential foreign tax credit available to offset Canadian income taxes.
U.S. real estate investors often utilize 1031 exchanges to swap one real estate investment property for another that allows capital gains taxes to be deferred. If a Canadian company or Canadian corporation acquires replacement property in the United States, the exchange may qualify as a tax-deferred transaction under the U.S. like-kind exchange rules or 1031 exchange rules. However, such a transaction will not qualify for the Canadian replacement property rules because the former property was not located in Canada.
Using A U.S. Corporation to Hold Real Property
A Canadian company or corporation may form a wholly owned U.S. corporate subsidiary to acquire U.S. real estate. Such a structure may be subject to Canada’s Foreign Accrual Property Income or FAPI. The FAPI regime is intended to prevent Canadian residents from avoiding Canadian income tax on passive investment income earned through a controlled foreign affiliate. The FAPI rules only apply to passive income held in a corporation (which is a controlled foreign corporation).
If the U.S. company earns active business income, its Canadian parent would not be taxed in Canada on the dividends it receives from the U.S. company from active business earnings. Article X of the U.S.-Canada income tax treaty may reduce the U.S. tax on dividends to 5 percent of the gross amount of the dividend if the beneficial owner is a company which owns at least 10 percent of the voting stock of the company paying the dividends. However, the 5 percent U.S. tax on dividends would not likely qualify for a foreign tax credit in Canada. With that said, if the U.S. company holding U.S. real estate is liquidated after the real property is sold and U.S. taxes corporate taxes have been paid, it is possible to U.S. withholding taxes on dividends.
As noted above, U.S. real estate investors often utilize 1031 exchanges to swap one real estate investment property for another that allows capital gains taxes to be deferred. If the U.S. corporation is carrying on an active business, the U.S. corporation may participate in a like-kind exchange transaction in the U.S. without triggering U.S. and Canadian tax.
The U.S. branch profits tax rules will apply to structures in which a Canadian company forms a U.S. corporation to hold U.S. real estate. The operation of the branch profits tax can be demonstrated in a simple example. Canberry, a Canadian company, has net equity (adjusted basis of U.S. corporate assets less U.S. corporate liabilities) in its wholly owned U.S. corporation at the end of tax year 1 of $4,500,000. Cranberry has effectively connected earnings and profits (effectively connected net income less U.S. income taxes) for tax year 2 of $1,000,000. The company acquired an additional $500,000 of U.S. assets during tax year 2 bringing its U.S. net equity at the end of tax year 2 to $5,000,000. Cranberry’s dividend equivalent amount is equal to its effectively connected earnings and profits reduced by the amount of its increase in U.S. net equity ($1,000,000 – $500,000). Its dividend equivalent amount for year 2 is, therefore, $500,000. A branch profits tax of $150,000 (30% x $500,000 = $150,000) would typically have to be paid in addition to the U.S. tax on tax year 2 taxable income of the U.S. corporation. However, the U.S.-Canada tax treaty reduces the branch profits tax to a rate of 5 percent on net income exceeding 500,000 Canadian dollars. Since Canberry is a resident of Canada, any branch profits would be reduced to 5 percent of the dividend equivalent after applying the 500,000 Canadian dollar exclusion.
Canadian investors considering forming a wholly owned U.S. corporate subsidiary to acquire U.S. real estate should understand that the U.S. corporation will be considered a U.S. person for U.S. tax consequences. Such a structure can have some unexpected consequences. This is because a U.S. corporate subsidiary is a U.S. shareholder for purposes of the controlled foreign corporation (“CFC”) rules of the Internal Revenue Code. A CFC is defined as a foreign corporation in which more than 50 percent of its total voting power or value is owned by U.S. Persons (U.S. individuals, U.S. trusts, U.S. corporations, or U.S. partnerships) who each own at least 10 percent of the combined voting power of all classes of the stock, or at least 10 percent of the total value of shares of all classes of stock. See IRC Sections 957(a), 951(a), and 951(b). For these purposes, certain attribution rules can apply to attribute stock ownership of a foreign corporation to U.S. persons, especially subsequent to the repeal of Internal Revenue Code Section 958(b)(4) under the Tax Cuts and Jobs Act of 2017. For example, consider a situation in which a foreign person (“FP”) owned all the stock in each of a domestic corporation (“Domestic Sub”) and a foreign corporation (“Foreign Sub”). Section 318(a)(3)(C) would cause FP to attribute its shares of Foreign Sub to Domestic Sub, thereby making Foreign Sub a CFC of Domestic Sub.
Internal Revenue Code Section 958(b)(4) previously prevented this result by preventing attribution of stock under Internal Revenue Code Section 318(a)(3) from a non-U.S. person to a U.S. person. The change to eliminate Section 958(b)(4) was made so that U.S. taxpayers would be unable to avoid CFC status by “de-controlling” a foreign subsidiary by causing the foreign subsidiary to issue stock to the new foreign parent after an inversion transaction. Even though this change was very much targeted at a specific type of transaction that was deemed abusive, the change has far greater and unintended effects as, even if a foreign corporation has ultimate beneficial owners who are all non-U.S. individuals, it is possible for a foreign corporation to be a CFC if either: (1) the ultimate beneficial owners (or any spouse, ascendant or descendant of the ultimate beneficial owners) own interests in a U.S. corporation or U.S. partnership, or (2) any entity in the ownership chain between the foreign corporation and the ultimate beneficial owners owns interests in a U.S. corporation or partnership. In addition, taking the example given above, under the plain language of Internal Revenue Code Sections 318(a)(2)(C), 318(a)(3)(C), and 318(a)(5)(A), Foreign Sub could technically be a CFC without any U.S. ownership.
Certain attribution rules can apply to attribute stock ownership of a Canadian company. (and potentially other foreign entities) to the U.S. Sub. In order to provide the IRS with the information necessary to ensure compliance with the Global Intangible Low Tax Income (“GILTI”) and Subpart F tax regimes, each year a U.S. person who owns 10 percent or more of the stock, by vote or value, of a foreign corporation must file a Form 5741 (Information Return of U.S. Persons With Respect to Certain Foreign Corporations). See Treas. Reg. Section 1.6038-2(a) and (b). Other persons who must file a Form 5471 include (1) U.S. persons who acquire a 10 percent ownership interest, acquire an additional 10 percent ownership interest, or dispose of stock holdings to reduce their ownership in the foreign corporation to less than 10 percent and (2) U.S. citizens and residents who are officers or directors of a foreign corporation in which a U.S. person acquires a 10 percent ownership interest or an additional 10% interest. See Treas. Reg. Section 1.6046-1(a)(2)(i) and IRC Section 6046(a).
A Form 5471 is usually utilized to reporting the following information regarding a CFC:
(1) Stock ownership, including current year acquisition and disposition;
(2) U.S. shareholders;
(3) GAAP income statement and balance sheet;
(4) Foreign income tax;
(5) Current and accumulated earnings and profits, including any actual dividend distribution during the year;
(6) The U.S. shareholder’s pro rata share of GILTI and Subpart F income and any increase in earnings invested in U.S. property; and
(7) Transactions between the CFC and shareholders or other related persons.
The Form 5471 is ordinarily attached to a U.S. person’s federal income tax return. The Form 5471 is filed annually with the IRS. The annual penalty for delinquent, incomplete, or materially incorrect filing starts at $10,000.
Congress has also enacted a requirement that each year certain reporting corporations must file a Form 5472 (Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business) and maintain certain books and records. See generally IRC Sections 6038A and 6038C. A domestic corporation is a reporting corporation if, at any time during the taxable year, 25 percent or more of its stock, by vote or value, is owned directly or indirectly by one foreign person. A foreign corporation is a reporting corporation if, at any time during the taxable year, it is engaged in a U.S. trade or business, and 25% or more of its stock, by vote or value, is owned directly or indirectly by one foreign person. A foreign person includes a nonresident alien individual, a foreign corporation, a foreign partnership, a foreign trust, a foreign estate, and any other person that is not a U.S. person. Under these rules, more than 25% of the U.S. Sub’s outstanding shares are directly owned by a foreign person. Thus, the U.S. Sub established by a Canadian company or corporation is a reporting corporation and has an obligation to annually file a Form 5472. In filing a Form 5472, the reporting corporation must provide information regarding its foreign shareholders, certain other related parties, and the dollar amounts of transactions that it entered into during the taxable year with foreign related parties. Any reporting corporation that fails to file a Form 5472 may be subject to a penalty of $25,000 for each tax year. If the failure continues after notification by the IRS, there is an additional penalty of $25,000 for each 30-day period or fraction. There is no upper limit on this penalty.
Any Canadian real estate investor considering utilizing a Canadian company or corporation to form a wholly owned U.S. corporate subsidiary to acquire U.S. real estate must understand that such a structure will likely trigger significant annual U.S. filing obligations and potential unexpected U.S. tax obligations. With that said, a major advantage of having a U.S. corporation carrying on an active business holding U.S. real estate is that it will likely file only a U.S. income tax return obligation in connection with the U.S. real estate. This may eliminate tax differences between Canada and the U.S. and avoid any potential mismatching associated between each country’s tax systems. Furthermore, under Article VII of the U.S.-Canada treaty, management fees generally are not subject to U.S. tax, assuming the Canadian shareholder receiving the fees does not maintain a permanent establishment in the United States. The disadvantage of using a U.S. company to own the real property is that losses arising from the property will be locked into the U.S. company and thus forfeit the option of being deducted in Canada. This is because Canada does not appear to allow losses in a U.S. company to be applied against Canadian sourced taxable gains.
Holding U.S. Real Estate Through an LLC
Some Canadian real estate investors may be tempted to form a limited liability company (“LLC”) to hold U.S. real property. LLCs are often utilized by U.S. investors for a number of tax and non-tax reasons. An LLC is not likely an appropriate investment vehicle for Canadian real estate investors. If a Canadian company or Canadian corporation forms a U.S. based LLC to engage in an active business in the United States, for U.S. tax purposes, the Canadian company or corporation will likely be regarded as carrying on business in the U.S. through a branch. If the LLC is treated as a disregarded entity for U.S. tax purposes, the LLC will be subject to a 30 percent branch profits tax. Such a structure would not qualify for an exclusion or rate reduction under the U.S.-Canadian income tax treaty.
Use of a Limited Partnership to Hold U.S. Real Property
Canadian real estate investors can hold U.S. real property through a limited liability company. A Canadian limited partnership can elect to be treated as a corporation or partnership for U.S. tax purposes. A partnership should be a Canadian partnership for Canadian income tax purposes if all the members of the partnership are Canadian residents. Canadian partners will need to file Canadian and U.S. income tax returns. The income tax returns would differ in terms of depreciation, whether interest may be deducted or capitalized, foreign exchange rules, and the utilization of losses. If the U.S. partnership is carrying on a trade or business, each general and limited partner is deemed to be carrying on a trade or business and is taxable in the United States on effectively connected income.
The disadvantage of using a partnership to own the U.S. real property interest is that the partnership will be subject to Canadian income tax if it increases the property’s mortgage above the property’s original cost and distributes the excess mortgage proceeds to its partners. Another disadvantage is that Canadians who invest through a partnership will not benefit in Canada from the tax deferral available in the United States under the like-kind exchange in Section 1031 of the Internal Revenue Code. A limited partnership is also subject to the FIRPTA rules discussed above.
Canadian real estate investors considering utilizing a limited partnership to hold U.S. real estate should utilize tiered partnership to hold U.S. real property. This arrangement should avoid any potential U.S. estate and gift taxes. This arrangement may also allow the Canadian partnership to file a U.S. tax return as a corporation, avoiding multiple filings by its Canadian partners. The Canadian partnership may also receive a credit against U.S. tax for any U.S. withholding tax paid by the U.S. partnership under Section 1446 of the Internal Revenue Code.
Investment in a U.S. Real Property through a REIT
Finally, a Canadian investor may consider utilizing a real estate investment trust (“REIT”) to hold U.S. rental investment property. In general, REITs have fully transferable interests and are widely held, having a minimum of 100 investors. REITs make current distributions out of income derived from U.S. real estate investments. The distributions are taxed in the United States as corporate distributions but there is no U.S. corporate-level tax. Under Article VII(c) of the U.S.-Canada tax treaty, however, the REIT must withhold U.S. tax at 5 percent on dividends paid by U.S. REIT: (1) to a Canadian resident individual owning 10 percent or less of the REIT; (2) if the dividends are paid regarding a class that is publicly traded and the beneficial owner is a person owning not more than 5 percent of any class of stocks; or (3) if the REIT is diversified, the owner owns 10 percent or less of the interest in the REIT. In all other cases, the U.S. withholding tax rate is 30 percent.
Distributions in excess of the REIT’s earnings and profits are treated as nontaxable returns of capital or, if the distributions exceed basis, as taxable gains. In either case, the distribution is subject to a 10 percent withholding tax, unless the FIRPTA exceptions for domestically controlled REITs or publicly traded companies apply. If a REIT distributes gains relating to the disposition of U.S. real property interest, shareholders are subject to FIRPTA tax, and the distributions are subject to a 35 percent withholding tax, unless the REIT’s stock is publicly traded and the Canadian shareholders do not own more than 5 percent of its stock. In the case of a domestically controlled REIT, any gain on the disposition of a REIT interest is not subject to U.S. tax. This may also be the case for any gains from a disposition of publicly traded stock if the seller has not owned more than 5 percent of the REIT’s stock.
Under FIRPTA, foreign investors are generally taxed on gain or loss upon disposition of U.S. real investments in the same manner as if the foreign investor were engaged in a trade or business within the United States and if such gain or loss were effectively connected with a trade or business.
One of the exceptions to the applicability of FIRPTA frequently relied on by foreign investors is the sale of stock in a domestically controlled REIT. REITs typically issue shares that trade on stock exchanges and are bought and sold like stocks. To qualify as a REIT, a company must comply with certain provisions of the Internal Revenue Code. These requirements include to primarily own income-generating real estate for the long-term and distribute income to shareholders. A REIT must also: 1) invest at least 75 percent of total assets in real estate, cash, or U.S. Treasuries; 2) derive at least 75 percent of gross income from rents, interest on mortgages that finance real property, or real estate sales; 3) pay a minimum of 90 percent of taxable income in the form of shareholder dividends each year; 4) be an entity that is taxable as a corporation; 5) be managed by a board of directors or trustees; 6) have at least 100 shareholders after its first year of existence; and 7) have no more than 50 percent of its shares held by five or fewer individuals.
A domestically controlled REIT is an entity in which non-U.S. persons hold directly or indirectly less than 50 percent of the interests in the REIT. Foreign investors frequently acquire U.S. real estate through a domestically controlled REIT and structure their exit in U.S. real estate as a sale of shares in such domestically controlled REIT instead of a sale of a free simple interest in order to avoid the FIRPTA tax. Therefore, the determination of whether a REIT is domestically controlled is often critical to a foreign investor’s investment decision.
Section 897(h)(4)(B) generally provides that a domestically controlled REIT is which less than 50 percent in value of the stock is held “directly or indirectly” by foreign persons. The Internal Revenue Code does not provide specific guidance interpreting the words “directly or indirectly.” In the past, the Internal Revenue Service or (“IRS”) has considered whether a foreign-owned U.S. corporation should be viewed as a U.S. person for purposes of determining whether a REIT is domestically controlled. According to the fact pattern in Private Letter Ruling 200823001 (June 5, 2009), a REIT was held by two domestic corporations that were owned in part by foreign shareholders. The IRS determined that the REIT was considered to be “domestically controlled” despite the fact that the REIT was indirectly owned by a foreign corporation. The Ruling refers to Treasury Regulation Section 1.897-1(c)(2)(i), which provides that “the actual owners of stock, as determined under Treasury Regulation Section 1.857-8, must be taken into account.” Treasury Regulation Section 1.857-8(b) provides that the actual owner of stock of a REIT is the person who is required to include in gross income any dividends received on the stock. The proposed regulations do not retain the reference to Section 1.857-8 in Section 1.897-1(c)(2)(i).
The proposed regulations introduce a new concept of look-through persons and non-look-through persons that will dramatically impact REIT planning. Under the proposed regulations, in order to determine if a REIT is domestically controlled, it is necessary to review each look-through person until you reach a non-look- through person. A look-through person is any person other than a non-look-through person and includes a regulated investment company, a REIT, an S corporation, a non-publicly traded partnership (domestic or foreign) and a trust (domestic or foreign). A public REIT is treated as a foreign person that is a non-look-through person.
A non-public domestic C corporation is treated as a look-through-person if it is a foreign-owned domestic corporation. A foreign-owned domestic corporation is any non-public domestic C corporation if foreign persons hold directly or indirectly 25 percent or more of the fair market value of the non-public domestic C corporation’s outstanding stock. This means that, contrary to prior guidance, a REIT shareholder that is a private taxable domestic C corporation is a look-through person if 25 percent or more of the value of its outstanding stock is held by shareholders which are foreign persons. The Treasury Department and the IRS intend this new foreign-owned domestic corporation rule to prevent the use of intermediary domestic C corporations to create domestically controlled REITs.While the proposed regulations import this new concept of look-through persons and non-look-through persons, they continue to rely only on actual chains of ownership and do not import the attribution or constructive stock ownership rules found in other parts of the Internal Revenue Code such as Sections 267 and 318.
The foregoing discussion is intended to provide the reader with a basic understanding of the principal alternatives and basic tax considerations of Canadian investment in U.S. real estate. It should be evident from this article, however, that this is a relatively complex subject. As a result, it is crucial that a Canadian real estate investor and his Canadian tax advisor review his or her particular circumstances with a qualified U.S. tax attorney when planning a proposed U.S. real estate investment.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or email@example.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.