Canadian investors generally have the same goals of minimizing their tax liabilities from their U.S. real estate and business investments, as do their U.S. counterparts, although their objective is 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 income taxes in Canada. Further, the United States has a special tax regime that is applicable to foreign persons. Specifically, if the non-U.S. person derives certain types of passive income, it is typically taxed at a flat 30 percent rate (without allowance for deductions), unless an applicable tax treaty reduces this statutory rate. In contrast, if the U.S. activities of the foreign person rise to the level of constituting a “U.S. trade or business” (as opposed to being merely a “passive investment”), then the foreign person is taxed largely in the same manner as a U.S. person (i.e., on the net income from the business, at graduated rates). This article summarizes the U.S. and Canadian tax consequences of a Canadian acquiring a U.S. real property interest. The article also looks at the various relevant provisions of U.S. tax law, Canadian tax law, and the U.S.- Canada Income Tax Treaty that should be considered by a Canadian investor when investing in U.S. real estate.
Initial Determination Should be Made as to Whether the Canadian Investor Investment in U.S, Real Estate Constitutes a Trade of Business
Whenever a foreign investor looks to invest in United States real estate, an initial determination must be made as to whether the ownership and operation of the real property will be viewed as a U.S. trade or business. This factor would be relevant if the U.S. property will be a source of rental income. If it is, all U.S. source income effectively connected with the trade or business will be subject to U.S. federal income tax at ordinary rates. The U.S. income may also be subject to the branch profits tax (Many foreign entities operating a branch in the United States are subject to an additional 30-percent (or lesser treaty rate) tax on branch earnings not invested in branch assets or withdrawn from such investment).
The term “trade or business within the United States” is not defined in the Internal Revenue Code, although certain statutory prescriptions apply in specific instances dealing with the performance of services. As applied to foreign persons, a U.S. trade or business will be found to exist if there are regular, continuous and considerable business activities in the United States. Isolated or sporadic transactions will not usually be construed as the conduct of a trade or business. The ownership and rental of real property does not necessarily constitute a trade or business.
If the leasing of U.S. real estate by a Canadian investor does not give rise to a trade or business, income received from the rental of real property will be subject to a flat 30-percent tax which is sometimes referred to as “FDAP income.” The collection of such taxes is affected primarily through the imposition of an obligation on the person or entity making the payment to the Canadian investor to withhold the tax and pay it over to the Internal Revenue Service (“IRS”). This 30 percent withholding rate is not reduced under the U.S.- Canada Income Tax Treaty. The 30 percent withholding tax is based on gross income rental income received and there are no offsets for local real estate taxes paid by a tenant.
Because real property rental income ordinarily is attended by substantial deductions for such items as maintenance, depreciation, taxes, and mortgage interest, a tax on gross rental income could create substantial tax burdens even if the property generates a net loss. As a result, the Internal Revenue Code permits foreign investors to elect to be treated as if they were engaged in a U.S. trade or business with respect to all of its U.S. real property held for the production of income, even if the foreign investor is not in fact so engaged. See IRC Sections 871(d) and 882(d). Such an election enables Canadian investors to be taxed with respect to its net income from real property, thereby utilizing available deductions.
Treatment of Gains from U.S. Real Property
A Canadian investor in U.S. real estate must consider the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”). FIRPTA is codified in Internal Revenue Code Section 897. FIRPTA was designed to counteract the use of various techniques that have been developed to avoid income tax on the disposition of U.S. real estate. Section 897 provides that gain or loss realized by foreign investors or foreign corporations on the disposition of U.S. real property interests will be treated generally as if such gain or loss were effectively connected with a U.S. trade or business. In some instances, the tax will also apply to gains on the sale of stock in U.S. real property holding corporations (“RPHC”). A RPHC is defined to include any corporation (whether domestic or foreign) if the fair market value of whose U.S. real property interests equals or exceeds 50 percent of the sum of the fair market value of 1) its U.S. real property interests, 2) its interest in real property located outside the United States, and 3) any other of its assets that are used or held for use in a trade or business. Similarly, the disposition of an interest in a partnership that holds U.S. real property is treated as a disposition of a U.S. real property interest to the extent that it is attributable to the underlying U.S. real property interests.
The FIRPTA rules do not apply if the transferor is not a foreign person, if the disposition involves a sale of publicly traded stock in a U.S. corporation in which the Canadian investor owns 5 percent or less, or if the disposition relates to the sale of shares in a U.S. company that has either not been an RPHC during the last five years or that has disposed of all its U.S. real property interests and recognized all the gain therefrom.
The purchaser of a U.S. real property interest from a non-U.S. person or entity is, in general, required to withhold 15 percent of the purchase price, which can be claimed as a credit against U.S. federal tax. If there is an installment sale, the withholding amount is still based on 15 percent of the total price and not the amount of the installment. In some circumstances, a Canadian investor can apply to the IRS for a certificate authorizing a reduced amount of withholding tax (for example, if the 15 percent withholding tax exceeds the maximum amount of tax payable on the disposition). Under Internal Revenue Code nonrecognition provisions, there are some FIRPTA exceptions for transactions involving an exchange of one U.S. real property interest under Internal Revenue Code Section 1031 for another. However, the so-called 1031 or U.S. like kind exchanges often do not qualify as a rollover for Canadian income tax purposes.
Canadians that invest in U.S. real property through partnership should be aware of special withholding rules discussed in Notice 2018-8, 2018-7 I.R.B. 352 (Jan. 2, 2018) and Notice 2018-29, 2018-16 I.R.B. 495 (Apr. 2, 2018). These notices provide for a 10 percent withholding tax to the transferee of a partnership interest, with the partnership subject to potential additional withholding obligations.
Many Canadian investors hold U.S. real property through a U.S. corporation. From a planning point of view, if a U.S. corporation owns U.S. property, it may be advantageous to sell the property and pay U.S. corporate tax on the gain. Once the corporation has no real estate and has recognized all real estate gains, it would no longer constitute a RPHC and it may be possible to liquidate the corporation without any FIRPTA without consequences to the shareholders of the corporation.
Many Canadian investors plan to avoid U.S. estate and gift tax by placing U.S. real property in a Canadian corporation. Canadian investors then typically make an election under Section 85(a) of the Income Tax Act of Canada for Canadian tax planning purposes. Such planning does not impact the FIRPTA withholding rules. However, it may be possible to defer FIRPTA by making an election under Internal Revenue Code Section 897(i) to treat the Canadian company holding U.S. real property as a U.S. corporation. Canadian investors may then potentially avoid FIRPTA withholding through a tax deferred contribution under the provisions of Internal Revenue Code Section 351.
Financing U.S. Real Property Acquisitions
A major decision in structuring a U.S. real estate investment concerns the manner in which the investment is financed. If a Canadian investor utilizes financing to acquire U.S. real estate, the deductibility of interest payments and withholding of interest payments must be considered.
As a general rule, interest on funds borrowed to purchase income-producing property is deductible for U.S. and Canadian income tax purposes. However, the rules regarding the deductibility of interest payments can be complicated and each country has its own distinct rules regarding the deductibility of interest payments.
For Canadian purposes, Section 20(1)(c) of the Income Tax Act 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. Section 18(2) requires the capitalization of interest relating to vacant land and interest during construction.
If a Canadian corporation is used to acquire U.S. real property, Sections 17 and 15 of the Canadian Income Tax Act should be considered if the corporation uses retained earnings to make interest-free loans to Canadian investors. If such a loan is outstanding for more than a year and interest is computed at an unreasonable low rate, the lender could be deemed to have received taxable interest at the current prevailing interest rates. However, this imputation of interest does not apply if the borrower is a subsidiary and the money was used in its business to produce income. There is also an exception to this rule for loans made between Canadian corporations to U.S. corporations owned by Canadian individuals. In these cases, for Canadian tax purposes only, such loans might be treated as a permissible shareholder loan.
As for the deductibility of interest payments for U.S. tax purposes, the Internal Revenue Code has intricate interest allocation rules and limitations on interest deductions.. Canadian corporations must allocate interest payments for U.S. purposes not on a tracing basis, but on an interchangeable basis. This means that the amount of interest that is deductible in the United States will likely differ from the amount deductible in Canada. The U.S. thin capitalization rules must be considered. When a corporation issues excessive liabilities relative to the capital contribution that it has received, the holders of corporate notes bear significant risks. Such a corporation is regarded as “thinly capitalized.” Even though the instrument may bear all the formalities normally associated with a debt instrument, the holders of this debt are depending largely on the profitability of the enterprise rather than underlying assets to assure payment.
This type of risk is more typically associated with an equity investment. At some point, the debt-equity ratio is so large that the instrument should be regarded as an equity investment. Prior to 2017, Internal Revenue Code Section 163(j) operated to prevent foreign investors from eroding the U.S. federal income tax base through tax deductible interest payments to tax exempt related parties. The rule applied when a debtor’s debt-to-equity exceeded 1.5 to 1 and its total “net interest expense” exceeded 50 percent of its “adjusted taxable income,” there would be a disallowance of a portion of its “related party tax-exempt interest.” The 2017 Tax Cuts and Jobs Act modified Internal Revenue Code Section 163(j) interest expense provisions in that it eliminated the 1.5 to 1 ratio requirement. It also eliminated the disallowed interest provision regarding payments to a related person. The new interest limitation rules under Internal Revenue Code Section 163(j) provide that the deduction allowed for business interest expense in any taxable years, regardless of to whom the interest is paid, generally cannot exceed the sum of 1) the foreign investor’s “business interest income” for the taxable year, plus 2) 30 percent of the foreign investor’s “adjusted taxable income” for the tax year.
The thin capitalization rules and Section 163(j) should be important considerations for any Canadian investors because under the U.S.- Canada Income Tax Treaty, there is generally no U.S. withholding tax on U.S. source interest paid to a Canadian lender.
U.S. Estate and Gift Tax
For many Canadian investors in U.S. real property, the most important federal tax consideration is U.S. federal estate tax and gift taxation. The United States imposes U.S. federal estate and gift taxes on certain transfers of U.S. situs property by “nonresidents not citizens of the United States.” Foreign investors are provided a unified credit of $60,000 against the U.S. estate and gift tax. United States real estate is U.S. situs property for purposes of the estate and gift tax. Canadian investors holding U.S. real estate directly or through a U.S. corporation should be concerned about the application of the estate and gift tax. It is unclear whether an interest in a partnership would attract U.S. estate or gift tax. The U.S.- Canada Income Tax Treaty significantly affects U.S. estate tax planning for Canadians investing in the U.S. In particular, certain Canadian investors are able to enjoy an estate tax marital deduction and to own a greater number of U.S. assets without incurring U.S. estate tax consequences. However, note that the U.S.- Canada Income Tax Treaty makes no changes in the U.S. gift tax rules. See Article XXIX(B).
Various Ways a Canadian Investor May Hold U.S. Real Estate
Ownership by the Individual Investor
A Canadian investor may individually hold U.S. real estate. Direct ownership by a Canadian investor of U.S. real estate is generally not recommended because the individual will be exposed to the commercial risks associated with the property and the investor may be exposed to the U.S. estate and gift tax. FIRPTA would also apply to a disposition of the U.S. real estate. There are some advantages of direct ownership. First, an individual carrying on a trade or business in the United States is not subject to the U.S. branch profits tax. Second, the individual has the ability to increase the mortgage on the U.S. property without automatically triggering a gain or an income inclusion in both Canada and the United States.
Holding U.S. Real Estate Through Trust
Some Canadian investors prefer to hold U.S. real property through a Canadian irrevocable discretionary trust. Assuming the trust would be a non-grantor trust for U.S. federal income tax purposes, notwithstanding the fact that the real estate is involved in an active trade or business, the trust would not be subject to the branch profits tax. The trust would also not be subject to the U.S. thin capitalization rules. A Canadian trust would likely be required to pay tax in Canada at the highest marginal rate. However, it may be possible to reduce this tax by selecting a trustee from certain Canadian provinces. Canadian investors considering holding U.S. real estate through a Canadian trust should carefully consider the holding in Carron Family Trust v. The Queen, 2009 DTC 1287 and its appeal when deciding if it is possible to reduce Canadian tax by selecting a trustee in a specific province.
Holding U.S. Property Through a Canadian Company
Historically, Canadian investors have made their direct investments in United States real estate principally through corporate ownership structures. Frequently, a Canadian corporation was used as either the direct U.S. investment owner or as a holding company for a U.S. subsidiary (which, in turn, owned the U.S. real property). If a Canadian company carries on a trade or business or has effectively connected income, it must file U.S. corporate tax returns and pay U.S. corporate tax. Also, it must pay U.S branch profits tax at the rate of 5 percent on net income exceeding C $500,000 as per the U.S.- Canadian Income Tax Treaty. However, the branch profits tax can potentially be eliminated if the Canadian corporation maintains a U.S. branch and pays interest to a Canadian lender. As discussed above, one of the benefits of having a Canadian company acquire U.S. real estate, rather than having an individual directly own shares of a U.S. company, is the potential avoidance of U.S. estate tax. With that said, care must be exercised in capitalizing a Canadian company that owns U.S. real estate because of the U.S. thin capitalization rules.
Holding U.S. Real Property Through a U.S. Company
As indicated above, Canadian investors may hold U.S. property through U.S. companies. This is mostly done through a Canadian company which forms a wholly owned U.S. subsidiary to acquire U.S. real estate. Prior to establishing such a structure, an initial determination should be made whether the U.S. company would be regarded as carrying on an active, or an investment, business for Canadian tax purposes. To be exempt from Canada’s foreign accrual property income or “FAPI” rules, which would attribute rental income on an undistributed basis to the Canadian corporate shareholder, the U.S. company must employ more than five full-time employees.
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. Nevertheless, U.S. withholding tax at the rate of 5 percent would apply to dividends (as per the U.S.- Canada Income Tax Treaty), and no foreign tax credit would be available in Canada. If the U.S. company is liquidated after the U.S. real estate is sold and U.S. taxes have been paid, no U.S. withholding tax would arise on the disposition. An election can potentially be made under Section 93(1) of the Canadian Income Tax Act to treat the disposition as a dividend in the amount of the U.S. corporation’s remaining exempt surplus.
If the U.S. corporation is carrying on an active business, the corporation may participate in a like-kind exchange transaction without triggering Canadian tax. Direct ownership of a U.S. corporation by a Canadian individual is not typically recommended because of the individual’s exposure to U.S. estate tax and higher Canadian income tax consequences. However, by interposing a Canadian company to a U.S. corporate structure, the Canadian individual who is a shareholder of the Canadian company might benefit from the favorable tax treatment afforded Canadian dividends.
If the rental income of a Canadian foreign affiliate is considered passive income, the Canadian investor (whether an individual or a corporation) is taxed on the undistributed rental income, and the adjusted cost basis of its shares in the U.S. company is increased to reflect this income under Section 91, 92(1)(a) and 53(1)(d) of the Canadian Income Tax Act. When this income is distributed as a dividend, it is not taxable, and the Canadian Investor’s cost base in the shares for Canadian tax purposes could be reduced under Section 92(1)(b) of the Canadian Tax Act. Section 91 of the Canadian Tax Act will probably require a Canadian investor to include income in Canada of the participating percentage of FAPI of each share held by the Canadian investor.
A major cross-border tax advantage of having a U.S. company that is carrying on an active business of holding U.S. real estate is that the Canadian investor will only likely need to file a U.S. income tax return. This makes cross-border tax compliance easier, and any tax differences between Canada and the U.S. will not result in any mismatching. In regards to distribution of dividends, under the U.S.- Canada Income Tax Treaty, the U.S. withholding tax rate on dividends paid to a Canadian shareholder is 5 percent if the shareholder is a corporation that owns at least 10 percent of the voting stock of the U.S. corporation and 15 percent if the shareholder is an individual. Furthermore, under Article VII of the U.S.- Canada Income Tax Treaty, management fees generally are not subject to U.S. tax.
There is a major disadvantage to utilizing a U.S. company to hold U.S. real property.
Any losses associated with real estate arising from the property will be locked into the U.S. company and will not likely be deductible in Canada. This is because Canada does not allow losses from a U.S. company to be applied against Canadian profits on a consolidated basis.
The Dangers of Utilizing an LLC to Hold U.S. Property
Limited Liability Companies or “LLCs” are a popular investment vehicle in the United States. Although an LLC may work well for U.S. taxpayers, the same cannot be said for Canadian taxpayers. As a general rule, LLCs that are taxed as a flow-through structure are not appropriate vehicles for Canadian investors to hold U.S. real property. This is because an LLC is not subject to tax and as a result is not a resident for purposes of the U.S.- Canada Income Tax Treaty. This means, such an entity will not likely qualify for beneficial provisions of the U.S.- Canada Income Tax Treaty. Furthermore, an LLC is a flow-through entity for U.S. tax purposes, but an LLC is treated as a foreign affiliate for Canadian income tax purposes. This difference in treatment can result in mismatching for cross-border income tax purposes when the LLC is carrying on an active trade or business.
Holding U.S. Property through a Limited Partnership
Canadian investors may hold U.S. property through a partnership. Holding U.S. property through a partnership has two major disadvantages. First, due to the flow-through nature of partnerships for tax purposes, there could be mismatches of tax reporting for U.S. and Canadian tax purposes. Second, the disadvantage of using a partnership to own the U.S. real property 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. For Canadian tax purposes, the partner’s adjusted cost base becomes negative, triggering capital gain. For U.S. tax purposes, it is possible for the partners to have a negative capital account in the partnership interest, thus deferring a capital gain on capital distributions exceeding the property’s basis. Therefore, if the partnership is likely to increase the mortgage and distribute the mortgage proceeds to partners, consideration should be given to co-ownership, rather than a partnership. Third, holding U.S. real property through a partnership involves some risk of a U.S. estate tax exposure (at least when the partnership is engaged in a U.S. trade or business). However, in certain cases, partnerships that are Canadian partnerships for Canadian tax purposes may be advantageous. A partnership will be a Canadian partnership for Canadian income tax purposes if all the members of the partnership are Canadian residents. The advantages of having a Canadian partnership is it provides for rollovers (tax deferred transactions) of property to a partnership, a rollover on a partnership’s dissolution if each partner receives an undivided interest in each partnership asset and liability, a rollover for a partner’s departure, and a rollover for the conversion of a partnership to a sole proprietorship.
Non-Canadian partnerships do not qualify for rollovers, but a U.S. partnership with a Canadian company as the general partner and Canadian individuals or corporations as limited partners would qualify. The Canadian partners would file Canadian and U.S. income tax returns, although the returns would differ in terms of depreciation, whether interest may be deducted or capitalized, the tax treatment of soft costs, foreign exchange rules, and the utilization of losses. If the U.S. tax treatment is carrying on a trade or business, each general or limited partner is deemed to be carrying on a trade or business and is taxable in the United States on effectively connected income. If the partnership is not carrying on a trade or business, any non U.S. partner can make the net election under the Internal Revenue Code to be taxed in the United States on net effectively connected income.
A limited partnership is a flow through vehicle for both U.S. and Canadian tax purposes. The amount of deductible losses is restricted in Canada by the at-risk rules and in the U.S. by various limitations, including the U.S. passive loss rules. Section 96 of the Canadian Income Tax Act restricts the amount of a limited partner’s share of partnership losses that can be deducted to the limited partner’s at-risk amount. For Canadian tax purposes, partners are taxed on their pro rata share of the partnership’s computed gain or loss. Each partner includes his share of the partnership’s income or losses from all sources in his income for the tax year in which the partnership’s fiscal year ends. Any amount not deductible in computing the partner’s income is deemed to be a “limited partnership loss” that is deductible in later years against future partnership income.
For U.S. tax purposes, a partnership is required to withhold on FDAPI (not effectively connected income) that is included in the distributive share of a foreign partner, even if the income is not actually distributed. If partnership distributive income is effectively connected, withholding is not required under Internal Revenue Code Section 1441. However, the Internal Revenue Code requires partnerships to withhold (and make estimated tax payments) on foreign partners’ share of partnership effectively connected income, regardless of whether distributions are made.
If the partnership is not carrying on a trade or business, U.S. withholding tax applies at the rate of 30 percent on gross rental income, unless an election is made under the Internal Revenue Code to withhold tax on the effectively connected income.
Finally, a variation of the above discussed partnership rules would be the use of a Canadian company that qualifies as a “corporation” for U.S. income tax purposes and a “partnership” for Canadian tax purposes. The possibility of having such a conflicting characterization of favorable tax results in both the United States and Canada. The Canadian partnership can elect to be treated as a corporation for U.S. tax purposes, which should eliminate Canadian exposure to U.S. estate tax, because the individuals will be deemed to own a non-U.S. corporation. This arrangement would also allow the Canadian partnership to file a U.S. tax return as a corporation, avoiding multiple filings by its Canadian partners.
Investment in a U.S. REIT
Finally, a Canadian investor can hold U.S. real property through a real estate investment trust or “REIT.” In general, REITs have fully transferred interests and are widely held, having a minimum of 100 investors. REITs make current distributions out of income derived from U.S. real estate investors. The distributions are taxed in the United States as corporate distributions but there is no U.S. corporate-level tax. Under Article X, paragraph 7(c) of the treaty, however, the REIT must withhold U.S. tax at 15 percent on dividends paid by the REIT: 1) to a Canadian resident individual owning 10 percent or less of the REIT; 2) if the dividends are paid regarding a class of stock that is publicly traded and the beneficial owner is a person owning not more than 5 percent of any class of stock; 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 rate is 30 percent.
Conclusion
The foregoing discussion is intended to provide a basic understanding of the principal planning alternatives and the basic U.S. and Canadian tax considerations of foreign investment in U.S. real estate. It should be evident from this article, however, that this is a complex subject. In addition, it is important to note that this area is constantly subject to new developments and changes, as the United States and Canadian governments promulgates new tax laws. As a result, it is crucial that a Canadian investor retain a qualified international tax attorney. With careful individualized tax planning, a Canadian investor may substantially reduce his or her U.S. and Canadian tax liabilities emanating from U.S. real estate investments.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice in both tax planning and tax controversy work in the international and domestic arenas. He has advised clients in both outbound and inbound tax planning for international clients, with a subspecialty of addressing FIRPTA and treaty related issues for foreign investors investing in the United States. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosds@sftaxcounsel.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.