Practitioners’ Corner
Nonresident Investment in Canadian
Real Estate
by Jack Bernstein
Jack Bernstein is with Aird & Berlis LLP in
Toronto.
T here recently has been substantial invest-
ment activity by nonresidents of Canada in
Canadian rental properties and development pro-
jects. This article summarizes the major Cana-
dian factors to be considered in selecting the
appropriate vehicle to hold the property. The ob-
jectives are to minimize Canadian taxes on profits
and Canadian withholding taxes, maximize for-
eign tax credits in the jurisdiction of the investor,
avoid provincial capital taxes and Canadian large
corporations tax, and provide limited liability.
This article highlights investments by U.S.
investors.
Investment by a Canadian
Corporation
A nonresident of Canada may incorporate a Ca-
nadian corporation to acquire a Canadian real
property. A U.S. purchaser might consider using a
Nova Scotia unlimited liability corporation for
that purpose. That corporation is treated for U.S.
tax purposes in the same manner as a limited lia-
bility corporation. For U.S. tax purposes, the U.S.
resident is effectively deemed to own the property
directly. That may be desirable if the Canadian
corporation does not become taxable on the in-
come as a result of the deductible expenses (for ex-
ample, interest or capital cost allowance). For
Canadian purposes, the Nova Scotia corporation
is treated as a corporation.
Investors must use care in capitalizing the Ca-
nadian corporation. Although interest expense
generally is deductible for Canadian taxes to the
extent that it relates to the acquisition of a rental
property, Canada has thin capitalization rules
that would operate to disallow an interest deduc-
tion to the extent that the corporation is thinly
capitalized.
Subsection 18(4) of the Canadian Income Tax
Act sets out Canada’s thin capitalization rules
and restricts the deduction for interest paid or
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payable in a tax year by a corporation resident in
Canada on debts owed to a specified nonresident.
If the ratio of those debts to the corporation’s eq-
uity exceeds 2 to 1, the excess interest is not de-
ductible. The rules are complicated and require
the corporation to calculate average monthly
amounts. Equity includes the retained earnings
at the beginning of the year, the average of con-
tributed surplus at the beginning of a calendar
month, and the average of paid-up capital at the
beginning of a calendar month. A specified non-
resident is a nonresident person or a nonresident-
owned investment corporation that is a share-
holder of the corporation that alone, or together
with non-arm’s-length parties, owns 25 percent of
the votes or value of the issued shares of any class
of the corporation. The rule is sufficiently broad so
as to encompass back-to-back loans.
While simple interest is generally deductible,
participating interest (for example, interest refer-
able to profits) is only deductible if it does not ex-
ceed a reasonable rate of simple interest (Sherway
Centre Limited, 98 DTC 6121 (FCA)).
For a development project, interest must be
capitalized if it relates to vacant land or is in-
curred during construction (subsection 18(2) and
18(3.1) of the Income Tax Act).
Section 21 of the Income Tax Act allows a tax-
payer to effectively capitalize all or part of the in-
terest by treating it as part of the cost of
depreciable property. However, the maximum
amount on which the election can be made is re-
stricted to the interest that would otherwise be
deductible under the thin capitalization rules.
Canadian withholding tax will apply on inter-
est payments at the 25 percent rate, unless modi-
fied by a treaty. The withholding tax rate on
interest is reduced to 10 percent under the Can-
ada-U.S. income tax treaty.
Paragraph 212(1)(b)(vii) provides for a domes-
tic exemption from Canadian withholding tax for
interest paid by a Canadian corporate borrower to
an arm’s-length nonresident lender, if the loan
term is at least five years and there is generally no
obligation for the borrower to pay more than 25
percent of the principal amount within the five
years. It is possible to accelerate the capital pay-
ments in the event of failure or default, as defined
21 July 2003 • 249
Practitioners’ Corner
under the agreement, or in the case of involuntary
disposition of the property (for example, fire or ex-
propriation). The default events must be real, not
under the lender’s control, and set out in the
agreement. The exemption does not apply to any
participating debt. Participating debt is a debt ob-
ligation for which the interest is contingent or de-
pendent on the use of, or production from,
property in Canada, or is computed by reference to
revenue, profit, cash flow, or other similar criteria.
The debt qualifying for the exemption may be con-
vertible to equity.
A principal disadvantage of using a
Canadian corporation to hold real
property is the exposure for provincial
capital tax and federal large
corporations tax.
Article XXI of the Canada-U.S. income tax trea-
ty provides an exemption from withholding tax for
interest or dividends paid to a U.S. pension fund
that is not related to the Canadian payor corpora-
tion. In other words, that exemption is not avail-
able if the nonresident pension fund is a
controlling shareholder of the Canadian
corporation.
A Canadian corporation that is controlled by a
nonresident would not be a Canadian-controlled
private corporation. As a result, that corporation
would not be entitled to benefit from the
small-business deduction, which results in a low
tax rate — approximately 19 percent — on the
first $225,000 (to be increased to $300,000 by
2006) of active business income. It also would not
be entitled to receive a dividend refund on the
payment of dividends out of investment income.
As a result, that corporation would be subject to
the top Canadian corporate tax rate. A Canadian
corporation taxable in Ontario would be subject to
provincial tax at a corporate tax rate of approxi-
mately 37 percent.
In addition, there would be Canadian withhold-
ing tax on dividends paid to a nonresident share-
holder, unless the exemption for an exempt
organization in article XXI of the Canada-U.S. in-
come tax treaty applies. The withholding tax rate
is 5 percent if the dividends are paid directly to a
U.S. corporate shareholder (not to a corporate
partnership) owning at least 10 percent of the vot-
ing stock of the company paying dividends. Other-
wise, it is 15 percent of the dividend’s gross
amount. If the U.S. shareholder is a limited liabil-
ity company (LLC), the withholding tax rate is 25
percent as Canada Customs and Revenue Agency
(CCRA) currently takes the position that an LLC
250 • 21 July 2003
is not eligible for treaty relief. Canada and the
U.S. are negotiating a new protocol to the treaty
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that will remedy that problem.
The exemption from withholding tax on inter-
est and dividends for a foreign pension fund under
article XXI, paragraph 2, of the Canada-U.S. in-
come tax treaty does not extend to rental income,
capital gains from real property, or recaptured
depreciation.
If the Canadian corporation is a principal busi-
ness corporation (that is, a corporation whose
principal business is real estate), it may claim
capital cost allowance in excess of the net rental
income. To the extent that the Canadian corpora-
tion has a loss, the loss may be carried back three
years or forward for up to seven years. The loss
may be used to shelter any capital gain on a sale.
That is one advantage of a corporation as com-
pared to a nonresident trust, which may not carry
forward a noncapital loss to offset a gain on a sale.
A principal disadvantage of using a Canadian
corporation to hold real property is the exposure
for provincial capital tax and federal large corpo-
rations tax. Ontario capital tax is computed as
0.30 percent of taxable paid-up capital (a defined
term). It is deductible for federal and provincial
income tax purposes.
The federal large corporations tax is a capital
tax computed as 0.225 percent of taxable capital
employed in Canada (a defined term) and only ap-
plies if there is capital (including debt) in excess of
$10 million. The author has encountered Cana-
dian corporations owned by nonresidents that
were not subject to any income tax as a result of
the deduction for interest and capital cost allow-
ance, but were subject to substantial capital tax
and large corporations tax. The large corporations
tax is being phased out over a five-year period,
commencing in 2004 and ending in 2008. In the in-
terim, it is proposed in the 2003 federal budget
that the tax only apply to a corporation (or where
there are associated corporations in the group)
with aggregate taxable capital in excess of $50
million. The tax is not deductible against federal
or provincial income tax but is offset by any corpo-
rate surtax payable. Ontario also has announced
plans to eliminate its capital tax.
On disposition of property by the Canadian
corporation, one-half of any capital gain and the
full amount of recaptured depreciation is taxable.
As indicated above, noncapital losses may be
available to be carried forward to provide some re-
lief. Ordinarily, one-half of a capital gain is eligi-
ble to be paid out as a tax-free capital dividend to
a Canadian shareholder. However, that dividend
is subject to Canadian withholding tax when paid
to a nonresident. Assuming that the corporation
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pays tax at an approximately 37 percent rate on
one-half of the capital gain, and on the full
amount of the recaptured depreciation, the after-
tax amount would be subject to Canadian with-
holding tax at the 25 percent rate (unless modified
by treaty) on a dividend distribution. The Can-
ada-U.S. income tax treaty may reduce the with-
holding tax rate on the dividends to 5 percent or
15 percent. As indicated above, a nonresident pen-
sion fund may be exempt from withholding tax un-
der the provisions of the Canada-U.S. income tax
treaty, provided it is not a related party.
The aggregate corporate and withholding tax
on a capital gain realized in a corporation con-
trolled by a nonresident and distributed would be
between approximately 22.6 percent (if a 5 per-
cent withholding tax rate applied) and 38.9 per-
cent (if a 25 percent withholding tax rate applied)
of the capital gain. The aggregate corporate and
withholding tax on recaptured depreciation or in-
ventory gain realized in a corporation and distrib-
uted as a dividend would be between
approximately 40.5 percent (if a 5 percent with-
holding tax rate applied) and 52.75 percent (if a 25
percent withholding tax rate applied).
Shares of a Canadian private company are tax-
able Canadian property. No treaty relief is avail-
able if the company primarily owns Canadian real
property. On a sale of shares, the nonresident ven-
dor will be required to obtain a clearance certifi-
cate under section 116 of the Income Tax Act and
to pay tax based on the amount of the gain.
Use of a Nonresident Corporation
A nonresident corporation that carries on busi-
ness in Canada is required to file a Canadian in-
come tax return under part I. In addition to
ordinary corporate tax, the corporation is subject
to branch tax at a 25 percent rate, unless modified
by a treaty. Under article X (6) of the Canada-U.S.
income tax treaty, there is no branch tax on the
first $500,000 of income earned by associated
companies. Any income in excess of that amount is
subject to branch tax at the 5 percent rate. The re-
duced rates do not apply to a U.S. LLC. Branch tax
is imposed to ensure that the nonresident does not
avoid the tax that would otherwise have been
withheld on dividends paid by a Canadian corpo-
ration. A U.S. resident may wish to use an S Corp
to benefit from one tax level. The S Corp will pay
tax in Canada at approximately 37 percent plus
branch tax, if applicable. A credit is available on
the U.S. shareholder’s U.S. return for the Cana-
dian tax paid. An S Corp benefits from the treaty,
unlike an LLC.
Tax Notes International
Practitioners’ Corner
A nonresident corporation is subject to a pro-
vincial capital tax and large corporations tax (de-
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scribed above).
If the nonresident corporation earns income
from property, it is entitled to file the net election
for rental income under section 216 of the Income
Tax Act. Rather than have the Canadian 25 per-
cent withholding tax rate on the gross rental in-
come, the election permits withholding on net
rental income. The nonresident may deduct inter-
est relating to the property, capital cost allowance
(depreciation), property taxes, and property man-
agement and maintenance fees. The nonresident
must file a Canadian tax return.
No treaty relief is available if the
company primarily owns Canadian
real property.
Interest paid between nonresidents is subject
to Canadian withholding tax under paragraph
212(13)(f) of the Income Tax Act, if the debt is se-
cured by a mortgage on Canadian real property, or
under subsection 212(13.2), if the nonresident de-
ducts the interest in computing “taxable income
earned in Canada.” Taxable income earned in
Canada would not include rental income, if the
taxpayer makes a section 216 election. It would in-
clude business income, recaptured depreciation,
and capital gains.
If the lender is a nonresident pension plan and
the debt is secured by a mortgage, relief may be
available from Canadian withholding tax under
paragraph 212(14)(c), which enables the lender to
apply for a certificate of exemption (Form NR6A).
Unless there is treaty protection, the shares of a
nonresident corporation — the value of which is de-
rived primarily from Canadian real estate — will be
viewed as taxable Canadian property. As a result,
the compliance procedure in section 116 (requiring
a certificate and prepayment of tax at the rate of 25
percent of a capital gain and 50 percent of an inven-
tory gain on recaptured depreciation on a sale of
taxable Canadian property) would have to be fol-
lowed, and the nonresident vendor would be taxable
in Canada based on the amount of the gain. The
fourth protocol to the Canada-U.S. income tax trea-
ty provides relief for U.S.-resident shareholders of a
U.S. corporation owning Canadian real property.
Use of a Trust
A Canadian or nonresident trust may acquire
Canadian property. A trust will be a personal
trust if the beneficiaries do not pay for their inter-
est. For example, a nonresident of Canada may
21 July 2003 • 251
Practitioners’ Corner
make a gift of cash to a trust formed for the benefit
of beneficiaries (for example, children) who are
not residents in Canada. The trust may use the
settled funds to acquire the property. If the benefi-
ciaries purchase their interest in the trust, the
trust will be viewed as a commercial trust. A
non-Canadian trust is not a unit trust for Cana-
dian tax purposes.
A nonresident trust may be deemed to
be a Canadian resident when the trust
has either a resident contributor or
resident beneficiary.
The trust income, including a commercial trust,
is calculated as if the trust is an individual. The
trust will be taxable at an approximately 43 per-
cent rate. Although a deduction is available under
subsection 104(6) in computing income under part
I of the Income Tax Act to the extent that income
is paid or payable to a beneficiary, if a trust is not
resident in Canada throughout the year, subsec-
tion 104(7) prohibits the deduction.
Generally, the residency of a trust is deter-
mined by reference to the residency of the major-
i t y o f t h e t r u s t e e s. T h e r e s i d e n c y o f t h e
beneficiaries is not material for that determina-
tion. (See MNR v. Holden (1933), 1 DTC 243(SCC)
and Thibodeau Family Trust v. The Queen, 78 DTC
6376 (FCTD)). CCRA indicated in Interpretation
Bulletin IT-447, Residence of a Trust or Estate,
dated 30 May 1980, that a trust may be considered
to reside where a person, other than a trustee, ex-
ercises a substantial portion of management and
control. CCRA also considers that the dual resi-
dency of a trust is possible, although that was re-
jected in Thibodeau Family Trust.
If the trust is resident in Canada, part XII.2 of
the Income Tax Act provides for a 36 percent tax
on designated trust income payable to any benefi-
ciary, resident or nonresident. The part XII.2 tax
is deductible in computing taxable income under
part I. No part XII.2 tax is payable by a trust for a
tax year in which the trustee has certified in the
part XII.2 tax return that there were no desig-
nated beneficiaries of the trust in that year. A des-
ignated beneficiary is a beneficiary that is a
nonresident. It may include a tax-exempt entity.
The designated income of a trust is income from a
business carried on in Canada or real property in
Canada. It also includes taxable capital gains that
have allowable capital losses from dispositions of
Canadian real property. A nonresident trust is not
subject to the provisions of part XII.2.
If the trust is a Canadian trust, the income is
subject to the 36 percent federal tax under part
252 • 21 July 2003
XII.2 and to Canadian withholding tax on income
distributions under part XIII. The Canada-U.S.
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income tax treaty imposes a 15 percent withhold-
ing tax on distributions by a Canadian resident
trust to a U.S. beneficiary. There is no withholding
on capital distributions.
A nonresident trust earning income from prop-
erty would be subject to Canadian tax only under
the Canadian withholding tax rules under part
XIII on the gross rental income.
Effective 1 January 2003, a nonresident trust
may be deemed to be a Canadian resident when
the trust has either a resident contributor (gener-
ally, a person resident in Canada who directly or
indirectly makes a gift, loan, or transfer property
to a nonresident trust) or resident beneficiary (a
Canadian resident beneficiary unless the trust
qualified as an immigration trust).
A trust often is viewed as an attractive vehicle
as it is subject to neither provincial capital tax nor
federal large corporations tax. A trust is subject to
neither the thin capitalization rule nor branch tax.
The beneficiaries or other nonresidents may loan
funds to the trust on an interest-bearing basis
without regard to the 2-to-1 debt-to-equity ratio.
If the trust earns income from property, then it
arguably is not subject to provincial tax, but also
will not qualify for federal abatement. The net
election is available under subsection 216(1) of
the Income Tax Act to permit a nonresident trust
to deduct interest, property taxes, maintenance
costs, and capital cost allowance (depreciation) in
computing the net rental that is taxable in Can-
ada. Interest may be deducted on unsecured loans
made to nonresident trusts by the nonresident
beneficiaries.
Under subsection 107(2.1) of the Income Tax
Act, a transfer of property from a commercial
trust to a beneficiary is deemed to take place for
proceeds equal to fair market value, and the bene-
ficiaries are deemed to have disposed of their in-
terest in the trust for an amount equal to the fair
market value of the property distributed to that
beneficiary.
A personal trust is subject to a deemed disposi-
tion on the 21st anniversary of the trust. That ap-
plies whether the trust was resident in Canada or
a nonresident. The deemed disposition rule does
not apply to a commercial trust.
Subsection 212(13.2) provides that when a non-
resident person (including a trust) pays or credits
an amount to another nonresident person, the
first nonresident person will be deemed to be a
person resident in Canada for withholding tax
purposes for the portion of the amount that is de-
ductible in computing the particular nonresident
person’s taxable income earned in Canada (as de-
Tax Notes International

fined — see above). Paragraph 212(13)(f) provides
that when a nonresident person pays an amount
as interest on a mortgage secured by real property
in Canada and the interest is deductible against
Canadian income, then the amount is subject to
Canadian withholding tax.
It is beneficial to have the nonresident trust
earn income from property and not carry on busi-
ness in Canada. For nonresident trusts earning
income from property, it is possible to structure in-
terest on loans from the beneficiaries to not be se-
cured by Canadian property so that an interest
deduction may be claimed on filing the net elec-
tion under subsection 216(1) of the Income Tax
Act. Subsection 212(13.2) will apply to require Ca-
nadian withholding tax on interest paid on a
rental property in the year of sale.
If the beneficiary of the nonresident trust is a
pension fund, then there may be treaty relief on
the withholding tax on the interest if the trust is
not carrying on business, and the pension fund is
not related to the trust (for example, article XXI,
paragraph 2, of the Canada-U.S. income tax trea-
ty). As indicated above, a nonresident pension also
may apply for the domestic exemption from with-
holding tax under paragraph 212(14)(c).
Paragraph 20(1)(c) of the Income Tax Act con-
tains the general rule for interest deductibility.
For interest to be deductible, it must be incurred
under a legal obligation to pay interest on bor-
rowed money used to earn income from a business
or property. It also may be an amount payable for
property acquired to gain or produce income from
property, or to gain or produce income from a busi-
ness. Section 67 of the Income Tax Act denies de-
ductions for unreasonable expenses. If the
interest payable by the trust does not result in a
loss, the related interest expense generally should
be deductible.
If a U.S. trust is used for the investment, U.S.
beneficiaries of the trust may wish to consider
whether it would be advantageous for U.S. tax pur-
poses to take advantage of the check-the-box legis-
lation so that the income may be taxable in their
hands, rather than be taxable to the trust. When a
taxpayer uses a trust, the potential exposure for li-
ability is another issue to be addressed. It is unre-
solved in Canada whether a beneficiary of a trust,
where the units are not publicly traded, is liable for
the liabilites of the trust. A Delaware business
trust benefits from limited liability. While it is of-
ten suggested that the beneficiaries of the trust
may not be liable for obligations of the trust beyond
the trust property, it has been customary to include
a comment in the risk portion of a Canadian real
estate investment trust that there is a theoretical
risk. The risk may be partially overcome by obtain-
Tax Notes International
Practitioners’ Corner
ing appropriate liability insurance, as well as by
including a stipulation in all contracts that re-
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course is to be had only to trust property. It may be
possible to overcome that concern by having a
non-Canadian limited partnership be the benefi-
ciary of the nonresident trust.
Use of a Non-Canadian Partnership
If a non-Canadian partnership invests in Cana-
dian real property, the tax consequences depend
on whether the income from the real property is
earned from carrying on business in Canada, or
whether the income is income from property. It
may depend also on whether any partner is a tax-
able corporation.
If a U.S. trust is used for the investment,
U.S. beneficiaries of the trust may wish
to consider whether it would be
advantageous for U.S. tax purposes to
take advantage of the check-the-box
legislation.
The issue as to whether the income is from
property or from carrying on a business is factual,
and generally is dependent on the number of ser-
vices that are provided. If only the minimal ser-
vices normally required by a tenant are provided,
the income would generally be income from prop-
erty. There is some concern that CCRA would pre-
sume that a partnership is formed for the purpose
of earning a profit, and, therefore, could be viewed
prima facie as carrying on business. CCRA’s tech-
nical interpretations have indicated that it is a
question of fact as to whether a partnership earns
income from a business or income from property.
If any of the partners in the U.S. partnership
are corporations and the partnership earns in-
come from a business, the corporate partners will
be subject to Canadian tax under part I of the In-
come Tax Act, Canadian branch tax, large corpo-
rations tax, and provincial capital tax.
If a partner in the partnership is an individual,
then that individual will be viewed as earning
business income subject to tax in Canada based on
progressive rates up to a maximum of approxi-
mately 43 percent. No large corporations tax or
capital tax applies to the individual partner. Sub-
section 212(13.1) applies when a partnership pays
interest that is deductible in computing its in-
come from a Canadian source to a nonresident
person. That provision applies whether the part-
nership earns income from property or from a
business. The partnership is deemed to be a resi-
dent of Canada, with the result that Canadian
21 July 2003 • 253
Practitioners’ Corner
withholding tax applies on the interest payment
to the nonresident person under paragraph
212(1)(b) of the Income Tax Act. The withholding
tax rate on interest payable to the United States is
10 percent. Presumably, a U.S. individual or tax-
able entity is entitled to a foreign tax credit for the
Canadian withholding tax.
If the nonresident partnership is viewed as
earning income from property rather than income
from a business, the nonresident partner will be
taxable under part XIII (the Canadian withhold-
ing tax provisions). However, rather than have Ca-
nadian withholding tax on gross rental income, it
is generally preferable for the taxpayer to elect
under section 216 of the Income Tax Act to be
taxed on a net basis. That would result in the non-
resident partners being subject to Canadian tax
rates on net income. A nonresident individual is
not subject to large corporations tax or capital tax.
However, a nonresident corporate partner is sub-
ject to capital tax. As indicated above, the partner-
ship may be required to withhold tax on interest
paid by it to a partner under subsection 212(13.1).
While a U.S. pension fund may be exempt from
Canadian tax under article XXI of the Canada-
U.S. treaty on dividends or interest from an unre-
lated Canadian entity, there is no special treat-
ment available for recapture or capital gains
realized on the sale of a Canadian property. CCRA
has confirmed that they will look through a part-
nership and allow the treaty exemption for the
proportion of the partnership income allocable to
a tax-exempt partner.
One difference between earning income from a
business and earning income from property is
that rental losses are not available to be carried
254 • 21 July 2003
forward against capital gains and recaptured de-
preciation in the latter case, if a net election is
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made under section 216 of the Income Tax Act.
However, if the partnership is viewed as carrying
on business in Canada, the partners are entitled
to carry forward losses. As a result, if the objective
is to earn property income, care should be exer-
cised in structuring the debt financing so as not to
trigger an annual rental loss.
If the partnership is earning property income
but not filing the net election in Canada, any pay-
ment by a Canadian resident to the partnership is
deemed to be a payment to a nonresident for with-
holding tax purposes. Part XIII should not apply if
the partnership is paying tax under part I as busi-
ness income, provided the appropriate waiver is
obtained from CCRA (regulation 805).
The thin capitalization rule relating to the fi-
nancing of a Canadian corporation does not apply
to the financing of a U.S. partnership. There may
be an issue as to whether the interest payments to
the nonresident partners by the partnership are a
payment of interest, rather than a distribution of
partnership income. That is relevant, because the
former are deductible to the partnership, while
the latter are not. The amount of interest charged
should be reasonable.
A partner, resident in Canada, would trigger a
capital gain if the property is refinanced and sur-
plus funds are to be distributed to the partners. A
Canadian resident partner cannot have a nega-
tive adjusted cost base (tax cost) of a partnership
interest in the partnership. That is often a prob-
lem where a partnership has both U.S. and Cana-
dian partners. ✦
Tax Notes International