6.3.1 Taxation of Investments in U.S Real Property by Canadian Investors
6.3.1 (a) - Introduction
There are many tax and legal considerations that must be weighed before making an investment in U.S. real property.
The best way is to build a financial model, depending on the complexity of the investment which can take into account, what the U.S. and Canadian tax impact will be to the operation of the investment, as well as to the sale or exit from the investment.
The starting point for any such analysis will be a business plan and projected financial statements that tax advisors can work with. The heart of any international tax planning lies in the process, and in teamwork between the international tax advisors, the investors, and the accountants, working together with the real estate lawyers. All of the tax and legal issues need to be put on the table so that they can be thoughtfully considered, and integrated (Canada – U.S.) tax advice can be provided.
An investor who intends to invest individually will be subject to exposure to U.S. estate tax liability in addition to personal liability for accidents, environmental, or other legal claims that may be made. The investor, however, may have a more favorable capital gains rate on the sale of his / her interest, and may, depending on the ultimate facts and legal structure, be subject to only one level of tax.
Investors who consider using either a Canadian corporation, U.S. Corporation, or some combination would avail themselves of a blocker for personal liability and also may escape liability for estate taxes. Higher corporate may apply both to ordinary income and income on the sale of the real property. Additional consideration will also have to be given to repatriation of profits under U.S. withholding rules, and to any applicable Canadian rules concerning FAPI, exempt surplus, and related dividend distribution issues depending on the precise facts.
As partnerships are not subject to tax at the entity level, they may provide investors with protection to personal liability, and provide a flow-through treatment for earnings, and permit more favorable tax rates on income and on disposition of the asset.
Potential disadvantages depending on the ultimate structuring may include exposure to U.S. estate taxation, and onerous withholding under section 1446.
6.3.1 (b) – Taxation of Rental Income from Real Property Investments
Foreign persons generating income from United States sources are potentially subject to one, or both, of two U.S. federal taxation regimes. Under the first regime, if a foreign person or corporation carries on a trade or business in the U.S., federal income tax is imposed on its net income, wherever derived, that is effectively connected with a U.S. trade of business. The tax on effectively connected income is imposed at the same rates that apply to a similarly situated U.S. person. An additional tax, the branch profits tax, may be imposed on the “dividend equivalent amounts” of a foreign corporation engaged in a U.S. trade or business. This is most often the case with rental real estate property investments in the United States.
To avoid the scenario of being subject to tax at a gross rate, investors may make an election under the Code to treat their rental income as being derived from the active conduct of a trade or business.
Under the second regime, a flat tax of 30 percent is imposed on a foreign corporation’s gross income from “interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income”, but only to the extent the amount is from sources within the United States and is not effectively connected with the conduct of trade or business within the U.S. by such person or corporation.
Once it has been determined that a particular individual or corporation is carrying on a U.S. trade or business, it must then be determined to what extent, if any, the income of such individual or corporation is “effectively connected” with such trade or business. In determining ECI, the Code generally distinguishes between U.S. source and non-U.S. source income in the first instance, and between FDAP and all other sources of income.
As a general matter, U.S. source FDAP income will be treated as ECI if such income meets an “asset use test or material factor test”.
The asset-use test generally applies to income that is of a passive nature and where the trade or business activities themselves directly give rise to such income.
The business-activities test applies where the income arises directly from the active conduct of the U.S. trade or business.
Typically, a NRA owning U.S. real property will elect to treat the rental income under section 871 ( d ) as effectively connected income or section 881 ( d ) to a foreign corporation to permit the investor allowable deductions such as those that may apply for interest, property taxes, depreciation, and property management costs. Making this election may also save future compliance costs in seeking refunds from gross withholdings.
6.3.1 ( c ) – Partnership Taxation Issues and Real Property Investments
Some of the potential benefits of using a partnership may include: a partnership is not taxable; there is no gain or loss recognized by the partnership or a partner on the contribution of property for an interest in the partnership; cash distributions are only taxable to the extent they exceed basis in a partner’s interest; and partner’s basis includes his/her share of partnership liabilities.
Generally, a business entity that is not classifies as a corporation under the regulations can elect its classification for federal tax purposes (“an eligible entity”). An eligible entity with at least two members can elect to be classifies as either an association (or thus a corporation) or a partnership. An eligible entity with a single owner separate from its owners. If an entity is disregarded, its activities ae regarded as those of a sole proprietorship, branch, or division.
The regulations provide a default classification for an eligible entity that does not make an election. Thus, elections are necessary only when an eligible entity chooses to be classified initially as other than the default classification or when an eligible entity chooses to change its classification.
Under the default classification rules, a domestic eligible entity is a partnership if it has two or more members, or is disregarded and an separate from its owner if it has a single owner.
In general, a foreign eligible entity is regarded as a partnership if it has two or more members, and at least one of the members does not have limited liability; as an association if all members have limited liability; or is disregarded as an entity separate from its owner if it has a single owner that does not have limited liability.
6.3.1 (d) – Taxation Issues and the Finance of Real Property Investments
Another set of issues that must be examined in connection with the investment by Canadians into U.S. real property are the cross-border financing issues relating to how the acquisition of the property will be funded, and where applicable, its operation financed. Financing may provide for an expense deduction in the U.S., and as well, for repayment of the principal debt on a tax free basis.
In examining potential investment alternatives, the impact of the financing, equity or debt, or some combination should also be considered.
Investors must also consider internal domestic rules that may apply to financing that are not limited to but may include: the debt-equity characterizations rules,; the earnings stripping limitation rules under section 163(j), the conduit financing regulations pursuant to section 7701 (1) and applicable rules; and branch level interest tax.
6.3.1 (e) – Taxation Issues and the Sale of Real Property Investments
Capital gains of foreign investors are generally not subject to U.S. taxation unless effectively connected with a U.S. trade or business of the foreign person, or the NRA is deemed to be a resident in the United States.
Section 1221 defines “capital asset” generally as any property held by a tax payer, with certain exceptions, including property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. Also excluded from the definition of capital asset is property used in the taxpayer’s trade or business, of a character which is subject to the allowance for depreciation provided for in section 167, or real property used in the taxpayer’s trade or business. In addition, section 1231 mandates capital gain treatment for certain gains and losses recognized on the sale of property used by the taxpayer in a trade or business, even if the property was not otherwise a capital asset, but provides that property used in the trade or business excludes, among other things, property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.
On the issue of whether a gain is to receive capital vs. ordinary treatment, section 1221 has been held to differentiate between the “profits and losses arising from the everyday operation of a business” on the one hand, and “the realization of appreciation in value accrued over a substantial period of time” on the other.
The United States generally imposes a flat 30 percent tax, collected by withholding, on the gross amount of U.S. source investment income payments including non-capital gains earned by NRA individuals and foreign corporations. As a general rule, the regulations provide that the 30 per cent tax will not include gains from the sale or exchange of property to a foreign person who is not engaged in a trade or business in the United States. The 30 per cent tax will, however, apply to certain gains involving timber and coal. Moreover, the 30 per cent tax will also apply on certain gains from the sale or exchange of intellectual property to the extent such gains are from payments that are contingent on the productivity, use, or disposition of the property or interest sold or exchanged.
The foreign investment in Real Property Tax Act of 1980 (FIRPTA) is a jurisdictional provision because it subjects gain or loss of a foreign person from the disposition of a U.S. real property interest (USRPI) to tax as if the taxpayer were engaged in a trade or business within the U.S. and the gain or loss were effectively connected with such trade or business. As a result, FIRPTA represents an exception to the general non-taxation treatment of foreign investors with U.S. source capital gains that are not effectively connected with a U.S. business of the taxpayer. By definition, FIRPTA generally does not apply to the sale or exchange of stock in a foreign corporation. In addition, an interest held in the stock of a publicly traded corporation may, under certain conditions, not be a USRPI.
Under section 897, “U.S. real property” includes sales of interests in parcels of real property as well as sales of shares in certain U.S. corporations that are considered U.S. real property holding corporations under section 897 ©.
The term “Unites States real property interest” (USRPI) includes an interest in real property located in the United States, and any interest in any domestic corporation unless the taxpayer establishes that such corporation was at no time a United States real property holding corporation.
The term “United States real property holding corporation” (USRPHC) means any corporation if the fair market value of its United States real property interests equals or exceeds 50 per cent of the fair market value of the following:
1 – its USRPI,
2 – its interests in real property located outside the United States,
3 – any other of its assets that are used or held for use in a trade or business.
Section 897 may also apply to the sale or exchange of a foreign person’s interest in a partnership, trust or estate. Hence, the consideration or value of property received by a foreign person in exchange for all or a part of its interest in a partnership, trust, or estate, shall, to the extent attributable to USRPI, be considered as an amount received from the sale or exchange of such property in the United States.
Under section 1445, persons purchasing U.S. real property interests from foreign persons, certain purchasers’ agents, and settlement officers are required to withhold 10 per cent of the amount realized on the disposition. Required withholding is intended to ensure U.S. taxation of gains realized on disposition of such interests. Withholding is required unless one of five exemptions applies. The withholding obligation is generally imposed on the transferee.
6.3.2 Explanation of Treaty under U.S Law
6.3.2 (a) – Taxation of Real Property Income
Article VI (I) provides that income derived by Canadian investors in real property situated in the U.S. may be taxed by the United States.
Income from real property includes:
Income from agriculture, forestry or other natural resources.
Income from an overriding royalty or a net profits interest in a natural resources.
Article VI (3) clarifies that the U.S. may tax income derived from the direct use, letting or use in any other form of real property and to income from the alienation of real property. In the case of a net lease of real property, if a net election has not been made, the gross rental payment is treated as income from the property.
6.3.2 (b) – The Term Real Property
The term “real property” includes land, growing crops and timber, mines, wells, and other natural deposits; and improvements on land such as buildings, apartment houses, factories, office buildings, warehouses, garages, railway or bus stations, and certain inherently permanent structures such as wharves and docks, bridges, fences, oil derricks, oil and gas pipelines, oil and gas storage tanks, grain storage bins and silos.
6.3.2 (c) – Capital Gains from Real Property and Article XIII Considerations
Article XIII (1) authorizes the U.S. tax gains derived by a resident of Canada from the alienation of real property situated in the United States.
Advisor’s Guide to Canada – U.S. Tax Treaty
By: Vitaly Timokhov, Raymond Montero, David Kerzner
Published by: Thomson Carswell
The Accounting and Tax