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Larry Stolberg CPA, CA
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Increase in rate of withholding of tax on dispositions of United States real property interests-CLARIFICATION ON WITHHOLDING CRITERIA!

On December 18th, President Obama, signed H.R. 2029, the tax (the “Protecting Americans from Tax Hikes Act of 2015”) and spending bills (Consolidated Appropriations Act, 2016) to fund the government for its 2016 fiscal year.

The December The Act increases the rate of withholding from dispositions of U.S. real property interests under §1445 from 10% to 15%.

If the acquired property is used as residence by the purchaser for at least 50% of the number of days during each of the first two 12-month periods following the date of purchase, then there is no withholding if the sale price is up to $300K. If the sale price for the residence meeting the foregoing use test is over $300k but under $1M, there is withholding but at 10%.

Properties without the foregoing intent to occupy or properties with the intent to occupy with a sale price over $1M, will attract the 15% withholding rate.

The increase in the withholding tax rate should cause those taxpayers with losses or nominal gains or those renters with passive activity loss carryovers, to apply for a withholding certificate using IRS Form 8288-B to reduce the withholding to an amount equivalent to their effective tax. This application (8288-B) must be received by the closing date and the IRS should act within 90 days of receipt. Otherwise refunds are only available upon filing the non-resident tax return (ie., 1040NR/1120F) reporting the disposition and currently takes about 6 months for processing.

Canadians selling U.S. real estate

As you may be aware of there is a tax withholding requirement on the sale of U.S. real estate by non-U.S. persons. This does not exempt the vendor from filing a U.S. tax return to report the sale and paying any tax payable or requesting a refund for excess federal tax withholding.

There are certain exemptions from the withholding such as if the purchase price is under $300K U.S. and the buyer is using the property as their home. For this exemption to be valid, the IRS regulations governing this provision must be followed with a certification from the purchaser to protect from penalties on the failure to withhold.

Without any legislative FIRPTA withholding exemptions, the withholding can be reduced to what the estimate tax would be on the capital gain that is reported on the tax return, only, by filing IRS form 8288-B application for a withholding certificate by the closing date of the sale.

If this is done and accepted you can have the withholding tax in your hands sooner than waiting for a refund upon filing the U.S. tax return next year.

It is my understanding that it is taking up to 6 months for refunds from filing the non-resident tax returns because the NR returns must be paper-filed.

Small Business Inter-corporate Dividends

Revisions to Section 55 of the Income Tax Act (“ITA”) may prevent the tax-free payment of inter-corporate dividends within a related corporate group.
With the exception of Part IV tax where applicable, the related party exemption per S55(3)(a) will no longer be available to allow cash dividends say paid from Opco to Holdco unless there is safe income in the payor corporation at the time of the dividend payment.
A broader “purpose test” in section 55 will convert the cash dividend to a capital gain if there is insufficient post-71 tax retained earnings or what is generally called ‘safe income”. Many practitioners are concerned in that old files of tax returns and statements are not available to determine what the safe income is at the particular time. For the most part, retained earnings may be representative of safe income however in certain situations, it will not be such as fast write off of depreciable assets for tax purposes as opposed to a slower rate for accounting, safe income will be lower that retained earnings.
One may make the S55(5)(f) “designation” with the T2 to minimize the risk of the conversion to a capital gain.
Another option would be to freeze the OPCO shares and redeem over time the new special shares. In this regard, an inter-corporate share redemption is exempt under the S55(3)(a) related party exemption, so the safe income at the time of the freeze which is moved as part of the share exchange from the existing common shares to the new special shares, even though it may not be accurately determinable, does not cause a problem. The new common shares issued after the freeze would attract post-freeze safe income to which one may track going forward.
Purification techniques utilized in the past to retain the QSBC status for the capital gains exemption may no longer work under the new S55 rules. For example,sprinkling special shares were generally issued to a sister holding company to move discretionary cash dividends. Such dividends were generally exempt under Part IV due to the S186(2) connected corporation rules but also exempt under S55 due to the related party exemption. As these shares never had any safe income attributable to them and payment of dividends would reduce the value of the common shares or what is defined in the legislation as a reduction in the fair market value “of any share”, the dividend payment would likely result in a capital gain to the sister Holdco. As their redemption value was always a nominal amount (generally their nominal issue price), their redemption would not move any dollars to the sister Holdco.
In his regard, new methods for purification need to be implemented to insure one does not fall into the S55 taxation issues and to retain the QSBC status of cash rich operating companies that wish to retain their QSBC status.

Income from business or from property

The taxation of corporate income from the rental of storage facilities appear to be a common business under regular review just like the motel/hotel and rental management business.

Basic tax rate concepts

The Canadian concept of integration is based on the premise that it should cost more to earn income directly or indirectly through a corporation. Unfortunately, nothing is perfect and the differences in provincial tax rates still cause some discrepancies.
The Canadian corporate tax rate on active business income (“ABI”) is lower that the tax rate on investment income. For 2016, the corporate tax rate in the province of Ontario on ABI is 15% whereas on investment income such as interest, dividends, royalties or rent), the rate is 50.2% subject to a refundable tax thereby reducing the effective rate to 19.53 when sufficient taxable dividends are paid.
The 2016 low rate of tax on ABI is on the first $500K of ABI, the ABI rate on any excess is at about 26.5%

The Canadian corporate structure for Canadian controlled private corporations is that one pays corporate tax and then a second level of tax by the individual shareholder when dividends are paid, not unlike utilizing U.S. C corporations. Canada does not have the S Corporation or LLC option.

Essentially being ABI, there is a tax deferral of about 38.53% for one in the top marginal tax bracket earning personally more than $200K. Tax deferral is the difference on tax in earning the income directly or indirectly through the corporation. On ABI over $500K, the deferral is about 27.03%. The absolute tax savings (cost) for 2016 is neutral for ABI up to $500K and an absolute tax cost of about 1.9% on ABI over $500K. Generally speaking, the absolute tax cost or savings is based on distributing all of the corporate income to the individual shareholders.

With regards to 2016 Ontario investment income (other than Canadian portfolio dividends), the tax deferral is about 3.4%, the same as in 2015, but for 2016, with an increase in the absolute tax cost to about 2.4% from 2.27%. For Canadian portfolio dividends, the deferral is about 1% for eligible dividends and about 7% for non-eligible. Eligible dividends comes from the GRIP account, generally dividends from Canadian public corporations. On distribution, there is no savings or absolute tax cost, thereby earning dividend income through a corporation as opposed to earning it personally remains neutral.

Specified investment business

Income from a “specified investment business” (“SIB”) is not considered ABI. By definition, a SIB is a business carried on by a corporation in a taxation year where the principal purpose of which is to derive income (including interest, dividends, rents and royalties) from property. Equipment leasing or non-real property rentals is excluded from the otherwise SIB rental. Income is not considered SIB income by statute if the corporation employs more than 5 full-time employees in the taxation year or if an associated corporation provides certain services to the corporation and could reasonably be expected to require more than 5 full-time employees if those services were not provided. Full-time is not one who works part-time hours.
In order to fall outside the ambit of the SIB provisions, more specifically where one cannot meet the foregoing full-time employee test, one would have to argue that the particular income is not income from property but income from a business. There have been numerous court cases on this subject matter, mostly dealing with rentals, where the taxpayer has to demonstrate based on the facts, that there is a degree of services being provided by the lessor or effort provided to earn the gross rental as opposed to the rent being considered strictly passive in nature. The rental of storage facilities appear to be a common business under regular review just like the motel/hotel and rental management business.

The 2015 Federal Budget announced a review or consultation on active versus investment business. The 2016 Federal Budget announced that the review is compete with nothing being amended.

One would expect better guidance on the subject matter, maybe similar to the U.S. passive activity rules and legislation pertaining to active or material participation.

Extended Filing Requirements for IRS Form 5472
On May 23, 2016, Internal Revenue Bulletin 2016-21 was released which proposes amendments to the regulations governing IRC 6038A.
The regulations are proposed to be applicable for taxable years ending on or after the date that is 12 months after the date these regulations are published as final regulations in the Federal Register.
IRS Form 5472 is filed if there is a “reporting corporation” that has “reportable transactions”.
Presently, regulation 1.6038A-1(c) (1) defines “Reporting Corporation” for purposes of IRC 6038A as follows:
For purposes of section 6038A, a reporting corporation is either a domestic corporation that is 25-percent foreign-owned as defined in paragraph (c)(2) of this section, or a foreign corporation that is 25-percent foreign-owned and engaged in trade or business within the United States. After November 4, 1990, a foreign corporation engaged in a trade or business within the United States at any time during a taxable year is a reporting corporation.
Regulation 1.6038A-2(a) (1) states that the reporting corporation must file IRS Form 5472 only when there are reportable transactions. A list of reportable transactions may be found in the instructions to IRS Form 5472 and in the regulations.
The proposed regulations will treat “domestic disregarded entities” that are wholly owned by foreign persons as “domestic corporations” for purposes of filing IRS Form 5472. Therefore if a LLC has “reportable transactions”, IRS Form 5472 will have to be filed, barring any safe harbor or other exemptions outlined in the regulations. The proposed regulations also include an additional category of “reportable transactions”.
Although not recommended for Canadian investors to directly invest in a LLC due to the mismatch of income and foreign tax credits as Canada does not recognize the flow-through status of a LLC, the foregoing proposed amendments will obviously affect Canadians who have invested in a LLC.

IRS Changes the ITIN Process

On August 4, 2016, the IRS released Notice 2016-48 outlining the renewal procedures pertaining to the implementation of the changes to the ITIN process as required by the PATH ACT, passed in December 2015.  There were also changes to requirements for dependents.

Only ITIN holders who need to file a tax return may need to renew. Others with ITINs for information returns or say for certain IRS waiver forms used for a reduction or waiver in withholding tax, do not have to renew. Note that most of these waiver forms require a 3-year resubmission to the payor of the particular income to which the tax withholding waiver relates.

ITINS issued after 2012
The new law will invalidate an ITIN issued to a taxpayer if a federal tax return has not been filed at least once in the last three years unless renewed by the taxpayer. This means, ITINS issued after 2012 and not used for tax returns in either 2013, 2014, or 2015 will expire as of January 1, 2017. The renewal period starts on October 1, 2016.
If you have been filing tax return annually, such as Canadian filing U.S. 1040X returns reporting their net rental income from U.S. real estate, the ITIN does not have to be renewed. However, say you have an ITIN issued to you when you acquired the U.S. condo but never filed a return because there was no rental or you sold the condo but then acquired a new property 4 years later, you will then need to reapply for a new ITIN.

ITINS issued before 2013
ITINs issued before 2013 that have been used in filing a tax return, regardless if you filed a return for any taxation year, the ITIN will have to be renewed this October. The first ITINs that will expire are those with middle digits 78 and 79. The IRS will mail letters to this group informing them of the renewal process. The schedule for expiration of ITINs that do not have middle digits of 78 and 79 will be announced at a future date.

Dependents from countries other than Canada or Mexico
Beginning October 1, 2016, the IRS will not accept passports for dependents that do not have a date of entry into the U.S., as a stand-alone identification document or dependents of military members overseas.
Affected applicants will have to submit either U.S. medical records for dependents under age six or U.S. school records for dependents under age 18 along with the passport. Dependents over age 18 can submit a rental or bank statement or a utility bill listing the applicant’s name and U.S. address, with their passport.

Streamlined Procedure May Not be Forever!
Recently I heard that U.S. citizens residing in the UK are receiving FATCA  letters advising them to get in touch with their financial advisors.
This is a signal that the sharing of information on foreign financial accounts of U.S. persons residing abroad is in full force and that  the OVDP or streamlined domestic and foreign offshore procedures could very well be short lived.

CRA Forms T1134 and T1135 Often Missed by Canadian U.S. Real Estate Investors
The T1134 and T1135 are a sample of Canadian foreign information returns like the U.S. 8938, 5471 or 8865.
A number of Canadians are investing in the U.S. real estate market with a U.S. limited partnership whose limited partners are solely Canadian residents and the general partner is a U.S. C corporation whose shareholders are also Canadian residents.
For those who want limited liability protection, this type of investment vehicle is often proposed because the conventional U.S. LLC does not work or is not treaty- friendly for an in-bound investment into the United States, from the Canadian perspective. This route has become the norm in recent years as opposed to the Canadian investor investing into the U.S. directly or indirectly through a Canadian corporation and/or a U.S. C corporation which work, however may raise repatriation tax issues and additional compliance fees. These type of investment have arisen in recent years due to the widespread Canadian investment in depressed U.S. real estate.
Likely Case Situation
Mr. X, a Canadian (non-resident alien for U.S. tax purposes), sets up the U.S. LP, usually Mr. X and family members are limited partners and the general partner is a U.S. C corporation wholly-owned by Mr. X or related members.  For the C corporation, it would be a foreign affiliate of the Canadian shareholders and in most cases, it would be a controlled foreign affiliate of the taxpayer requiring the filing of CRA Form T1134 (due 15 months after then end of the taxation year of the taxpayer).
The instructions to Form T1134 state that the form is not required where the foreign affiliate is inactive or dormant.  The administrative policy threshold for the filing of the T1134 is a function gross receipts of the foreign affiliate as well as the taxpayer’s share investment in the foreign affiliate and the value of property owned by the foreign affiliate. Where gross receipts are under $25KCdn. and the share investment is under $100KCdn. and the fair market value of the underlying assets of the CFA or FA are not over $1MCdn., then there is no requirement to file the form for the particular taxation year, however there still could be a FAPI issue.  Therefore, one may have to file for some years and not others.
It has recently come to my attention that although not written in the instructions to the T1134 form nor written in the legislation, a 2012 Windows on Canadian tax document, released on July 8, 2013 issued by CRA indicates that where there is a foreign affiliate who is a general partner, total gross receipts of the partnership are taken into account and not the general partner’s share. Based on this interpretation, is is more than likely that CRA Form T1134 will be required annually.
The T1135 is a required filing by the U.S. partnership because the partnership is regarded as a “Canadian specified entity” by virtue of its holding U.S. situs property with a cost amount greater than $100KCdn. and more than 90% of its members are not non-residents of Canada. If the T1135 is not required by the U.S. LP, it may be required by the Canadian partner, if their basis in the partnership is over $100KCdn.The T1135 is due 3 months after the end of the taxation year of the U.S. partnership.
Filing extensions?
Both T1134 and T1135 have no filing extensions available. The minimum penalties not filing for each annual form is $2,500 per year with higher penalties for gross negligence. A number of taxpayers are using the Canadian voluntary disclosure program to submit forms that are past-due of at least one year to waive penalties. The program allows one to go back 10 years. CRA Information Circular Ic00-1R4 outlines the criteria for the program with CRA Form RC199 being the voluntary disclosure application.
Computation of income for Canada
In addition to not filing the T1134, should the general partner be a controlled foreign affiliate (“CFA”), FAPI (“foreign accrual property income”), to the extent of the Canadian investor’s share of the CFA must be included in their tax return with a corresponding increase in basis of the share investment in the CFA.
Think of this a similar to the U.S. CFC or PFIC rules with a QEF election in place.
On the computation net rental or FAPI, net rental income should be determined under the Canadian Income Tax Act. Therefore, one needs the underlying basis of the property to determine capital cost allowance as opposed to taking the net rental from the IRS Form K-1. This information is required to report the correct net rental income on the Canadian tax returns for the limited partners.
Hopefully you will have that information available to you or even the IRS 1065 partnership tax return. Different results will occur, especially if the U.S. LP happens to own Canadian real estate which when sold, will require applications for clearance T2062/T2062A.  For Canadian clearance, they often ask for supporting documentation, so hopefully information reported in prior years has been done correctly.

Updated Canadian Corporate Tax Rates

For 2015, investment income may be subject to refundable tax of 26.67% of investment income. Portfolio dividends may be subject to Part IV tax of 33.33%. Part IV tax is added to the refundable dividend tax account, refundable when taxable dividends are paid at a rate of one-third times taxable dividends that are paid. Investment income includes net rental income, taxable capital gains.

The concept of tax integration in Canada is that one should be indifferent in earning income directly or indirectly through a Canadian corporation. Generally this concept is not always perfect due to differences in provincial tax rates. Generally there is a tax deferral as there is a positive  difference in the personal tax on income realized directly as opposed to the corporate tax on the same income earned by the corporation prior to distributing the income to the shareholder. The personal tax depends on your marginal tax rate before earning that income. However when the income is distributed to the shareholder in the form of dividends, there may be an absolute  tax cost of earning that particular income in the corporation over a number of years. The deferral or time from in leaving  the income in the corporation will  determine the cost versus benefit. Your individual cash flow requirements such as funds for RRSP contributions and personal expenditures will determine your renumeration mix.

 For 2015, those at the top personal tax rate in Ontario, realized a tax deferral on active business income under $500K of about 34.03% and about 23.03% on ABI over $500K. The absolute tax savings (cost) was about .12% and -1.28% respectively. For investment income (other than Canadian portfolio dividends), the deferral was about 3.4% with an absolute tax cost of about 2.27%. For Canadian portfolio dividends, the deferral is about .5% for eligible dividends and about 6.8% for non-eligible. Eligible dividends  comes from the GRIP account, generally dividends from  Canadian public corporations. On distribution, there is no savings or absolute tax cost, thereby earning dividend income through a corporation  as opposed to earning it personally is neutral.

2016 Tax Rate Changes

On December 7, 2015, federal government announced changes to the the taxation of private corporations as a result of the changes in the 2016 personal tax rates. Changes to rates for taxation years ending in 2016 will be based on proration of days of the taxation year falling in 2016.

The federal small business rate on income below $500K of active business income will decrease from 11% to 9% over  the period 2016-2019 with an annual reduction of .5%.

For 2016, a calendar year CCPC, the combined Federal and Ontario rate on active business income below $500K will be 15%. The February 25, 2016 Ontario Budget did not change Ontario corporate or personal tax rates. As a result, the combined Federal and Ontario rate on active business income will be 13.5% for 2019.

 In order to preserve integration, due to the change in federal corporate and personal tax rates in 2016, investment income is now subject to refundable Part I tax of 30.67% of  investment income, an increase from 26.67%. This forms the RDTOH (refundable tax on hand account). The Part I federal tax rate on investment income increases to 38.67% from 34.67% resulting in a combined 2016 Federal/Ontario tax rate of 50.2% from 46.2%.  Portfolio dividends will be subject to Part IV tax of 38.33% from 33.33%.  Part IV tax is added to the RDTOH account, refundable when taxable  dividends are paid at a rate of 38.33% times taxable dividends that are paid. Previously the dividend refund was 33.33% of taxable dividends paid. Investment income includes net rental income, taxable capital gains.

With regards to integration, for 2016, on ABI up to $500K, the tax deferral is about 38.53% for one in the top marginal tax bracket earning personally more than $200K. On ABI over $500K, the deferral is about 27.03%. The absolute tax savings (cost) for  2016 is neutral for ABI up to $500K and an absolute tax cost of  about 1.9%. With regards to investment income (other than Canadian portfolio dividends), the tax deferral is about 3.4%, the same as in 2015, but for 2016, with an increase in the absolute tax cost to about 2.4% from 2.27%.  For Canadian portfolio dividends, the deferral is about 1% for eligible dividends and about 7% for non-eligible. Eligible dividends  comes from the GRIP account, generally dividends from  Canadian public corporations. On distribution, there is no savings or absolute tax cost, thereby earning dividend income through a corporation  as opposed to earning it personally remains neutral. 

For non-CCPCs, the tax rate is 26.5% on investment income and active business income. This rate applies to non-resident corporations carrying on business in Ontario or making a Section 216 election to be taxed on rental income on a net basis by filing a T2 corporation return as opposed to the flat non-resident withholding tax of 25% on gross rentals.

Ontario February 25,2016 Budget

The budget reduces the Ontario Research and Development Tax Credit ("ORDTC") to 3.5% from 4.5%.  The Ontario Innovation Tax Credit ("OITC") is reduced from 10% to 8%. Both changes are effective for eligible R&D expenditures incurred in taxation years ending on or after June 1, 2016.

Limitation period for objection not running where Notice of Assessment sent to wrong address
The Income Tax Act provides a time period in which one may appeal a notice of assessment or reassessment. It is not unusual for a taxpayer not to have received the NOA. Although the taxpayer should advise CRA of any change in addresses or to correct an incorrect address on file, this case was decided on the premise of the lack of communication to the taxpayer of CRA’s assessment of tax payable for a taxation year.
Per CCH report on recent cases:
Pilgrim v. The Queen, 2015 DTC 1236
In September 2012, the Canada Revenue Agency issued Notices of Reassessment for the taxpayer for the 2009 and 2010 taxation years, and a Notice of Assessment for the 2011 taxation year. All of the notices were sent by mail but were not, according to the taxpayer, received by him. He became aware of a tax amount outstanding for previous years when he received his Notice of Assessment for the 2012 taxation year in the spring of 2014. He then brought an application for an extension of time to file Notices of Objection for the 2009, 2010 and 2011 taxation years. The Canada Revenue Agency took the position that the deadline for making such an application was no later than one year after the date by which the original Notice of Objection for the taxation year in question must have been served. Consequently, the application deadline had passed for all of the taxation years in issue. The application was dismissed.
During the course of the hearing of the application, it was determined that the address to which the notices at issue were sent was not the taxpayer's correct address, and that some items of correspondence sent to the taxpayer had been returned to the CRA as undelivered. The notices had been sent to the correct street address for the taxpayer's condominium complex, but had failed to specify the number of the taxpayer's unit. The Court held that where a taxpayer alleges that a Notice of Assessment or Reassessment was not communicated to him, the Minister bears the burden of proving that the notice was mailed or otherwise communicated to the taxpayer. As well, it is incumbent upon the Minister to mail or otherwise send a Notice of Assessment or Reassessment to a taxpayer's correct address. The jurisprudence provides that the fact that a notice which is sent to a wrong address leads to the conclusion that it was not issued at all. The Court concluded that the Notices of Assessment and Reassessment had therefore not been sent to the taxpayer and that the applicable limitation period had not begun to run. Consequently, the taxpayer's Notices of Objection for the 2009, 2010 and 2011 taxation years had been timely served, and the issue of the timing of his application for an extension of time was moot.
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