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Larry Stolberg CPA, CA

CRA says file NR4 SUM/NR4 for capital distributions

Canadian estates generally must file CRA Form T2062 clearance application where there is a disposition of a capital interest in an estate or trust to a non-resident of Canada, like to a U.S. beneficiary. This form is generally not required if the value of the interest is not derived from real estate. If it is derived from real estate per the Income Tax Act (“ITA”), it may be exempt under a tax treaty, hence the ITA says then the form is not required. Without a treaty and the ITA says yes to real estate, then the form is required. Reference should also be made to T2062C for a simplified notification where certain conditions are met.

The NR4 SUM/NR4 information due annually March 31st, is to report income credited to a non-resident even though there may be no withholding tax per Part XIII of the ITA or per the treaty. For example, most interest income credited to a non-resident is not subject to Part XIII withholding tax. If it was exempt or there was a reduction in rate per a treaty, then there is an exemption code that must be noted in box 18 or 28 of the NR4 slip.

It has been determined that subsection 212(11) of the ITA deems capital distributions to be income even though there is no Part XIII withholding requirement. An “S” exemption code is entered in box 18 or 28 of the NR4 slip to report that there is no withholding tax.

Failure to file this type of information return could result a penalty which is dependent on the number of NR4 slips or in this instance, the number of non-resident beneficiaries. For 1-5 slips, a flat $100 penalty. For more than 5 slips, the penalty is per day to a maximum. For example, 6-10 slips, the penalty is $5 per day up to $500. For 11-50 slips, the penalty is $10 per day to a maximum of $1,000.

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IRS looking at non-resident’s U.S. rental

The IRS has determined that a number of individual U.S tax returns filed by a NRA (“non-resident alien) have not attached to their tax return, the requirement per S871(d) of the IRC Code, a statement indicative of the election to treat the rental income as income effectively connected with a trade or business (“ECI”). The IRS has also determined that a number of non-residents have not reported rental income from U.S. property rentals. This could also be for those who have trust or partnership interests who automatically receive a K-1 or even those who receive the gross rent directly from the leasee where is no withholding agent or management company.

This forgoing election is outlined in the regulations and must be attached to the tax return for the first year in which the election is to be in place. Providing an IRS Form W8-ECI waiver to the payor of the rental income is only a mechanism to waive the 30% withholding on gross rent with the condition that the non-resident individual will file a tax return. The W8-ECI waiver is good for 3 calendar years and I doubt that management companies are following up or even know if the taxpayer is filing a return.

The election allows the filing of a tax return (1040NR for individual filings) to report on Schedule E gross rent less allowable deductions, hence taxing at income at graduated tax rates as opposed to a flat 30% rate on gross rent without the election where in effect the income is non-ECI. The importance of an accurate and complete tax return is that allowable reported rental losses, may in certain circumstances, be characterized as passive activity losses, applied in subsequent taxation years as well as in the year of sale to reduce adjustment gross income where a capital gain is realized on the disposition.

The filing of the annual return is generally a simple process. Without the filing, issues could arise on the sale of the property.

Interesting that IRS Form 8288 which is an information return filed to report the sale of the property by a non-resident and the remittance of the FIRPTA withholding tax on the gross sale price, does not have a specific question if the property was ever rented. In Canada, our counterpart, CRA Form T2062 has this question.

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Finance announcing changes to July 18, 2017 small business rules

During the week of October 16th,the Finance Minister announced changes to the July 18, 2017 proposed legislation.

The proposal to limit the availability of the capital gains exemption to active shareholders will be scrapped.

The proposed rules for determining the "reasonableness" of dividends paid to non-active shareholders will be simplified. It appears that capital gains on the sale of private corporation shares still could be included in "split income", by virtue of the definition of "split income", taxed at the top rate, to the extent that the capital gain is not sheltered by the taxpayer's available for the capital gains exemption.

The proposed changes to section 84.1 and proposed new section 246.1 which would convert in certain transactions capital gains or otherwise tax-free corporate distributions to taxable dividends will be scrapped. This means for now that the post- mortem "pipeline procedure" will remain, however still appearing to be dependent on implementation procedures as outlining in recent tax rulings.

A welcome announcement was that the federal tax rate applicable to the small business limit will be reduced from 10.5% to 10% effective January 1, 2018 and to 9% on January 1, 2019. With no Ontario changes, the combined federal and Ontario rate will be in 2019 13.5% from the present 15%. The rate on active business income in excess of the small business limit of the present 26.5% (combined federal & Ontario rate) will not change.

The suggested rules although not presently in proposed legislation, to revamp the taxation of passive income earned by private corporations as previously announced will leave the present rules intact for annual passive income of $50,000 or less, meaning the refundable tax treatment of such income will remain the same.

Refundable tax treatment is a mechanism for the corporation to obtain a dividend refund of federal tax previously paid on passive income when taxable dividends were paid. The concept of integration is that it should not be more or less costly to earn investment income directly or indirectly through a private corporation.

It appears that income in excess of this $50K limit will be effectively taxed at a higher rate, with the implication that there would no refundable tax treatment on this amount as suggested in July. This means that the absolute tax cost of earning investment income in a private corporation will increase significantly as opposed to earning it directly by the shareholder.

Revised proposed legislation will be released to amend the July 18th proposals, likely before the end of the year, however details with respect to changes to the taxation of corporate taxation may be released as part of the 2018 federal budget.
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Revision to Corporate Surplus Stripping Rules

These rules where designed to cause a deemed taxable dividend to individuals who receive share consideration and/or a promissory note on a non-arm’s length transfer of shares of a corporation resident in Canada. This could occur where the share consideration has a paid-up capital greater than of the transferred shares and/or where a promissory note exceeds a notionally adjusted tax basis of the transferred shares.

For example, if father sold shares of Fatherco to Sonco at fair market value for a promissory note, section 84.1 would deem father to have received a taxable dividend equivalent to the promissory note. Whereas if father sold the shares first to son for a promissory note and then son would transfer those shares to Sonco at that fair market value (ie, his tax basis), there would not be a deemed dividend to father.

However, if father claimed his available capital gains exemption on the sale of the shares to son and son took a promissory note equivalent to that fair market value on a subsequent transfer to Sonco, son would then have a deemed dividend because his notional tax basis for purposes of this tax provision would be nil.

The grind of the tax basis looks back to any prior non-arm’s length transfer of those shares or substituted shares where the capital gains exemption was claimed.

The July 18, 2017 proposed rules will now grind the tax basis on any individual share transfer where a capital gain was realized, regardless if the capital gains exemption was previously claimed by a prior non-arms' length transferor.

In the foregoing example, if father did not claim his available capital gains exemption on the sale of Fatherco shares to son, then 84.1 would not apply when son transferred the shares to Sonco. Now it will apply on son’s transfer to Sonco.

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Post-mortem tax planning affected by July 18th proposals

The proposed revisions to the corporate surplus stripping rules (section 84.1 of the Income Tax Act) will affect the post-mortem pipeline procedure.

On death, shares of OPCO are deemed to be disposed at fair market value, triggering a capital gain if the shares do not vest in a surviving spouse or spousal trust.

The estate acquires the shares at this fair market value. The estate may sell or liquidate OPCO, resulting in corporate tax on the sale or distribution of appreciable corporate assets in addition to tax to the estate on a deemed dividend arising on the redemption of the shares held by the estate. The share redemption also causes a capital loss (assuming certain stop-loss rules are not in play) that may be carried back to the terminal tax return to eliminate the capital gain if this transaction is done within the first taxation year the estate. If the share redemption is done after the first year, then you would have double tax, tax at capital gains rates on the terminal tax return and a second tax at dividend rates to the estate with a combined tax close to 70%.

The commonly used “pipeline procedure” allows the estate to transfer the OPCO shares to NEWCO for a promissory note which would be repaid tax-free to the estate and then to the beneficiaries as a capital distribution, resulting in only capital gains tax on the terminal tax return.

In recent years, CRA has questioned the distribution of the promissory note and has taken the position that the distribution is a deemed dividend under another provision of the Act because it was regarded as a distribution on the winding up or discontinuance of the business carried on by OPCO. However, CRA has issued a number of tax rulings that if OPCO was not wound up for a specific period, they would not assess this deemed dividend. If it was assessed then you could have both capital gains tax on the terminal tax return and tax as a dividend upon the repayment of the promissory note assuming the shares were not redeemed within the first taxation year of the estate.

A transfer after July 17th of OPCO shares by the estate to Newco will regardless of the tax rulings, will cause a deemed dividend to the estate due to the revisions to section 84.1.

To date there has been no comments on the status of potential pipeline transactions that are currently waiting for confirmation of their ruling requests.

At the end of the day, the revisions to section 84.1 will convert taxation at capital gains rates to taxation at dividend tax rates.

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Curtailing Income Splitting Opportunities for Small Business Corporations

If the proposed July 18, 2017 legislation is passed, commencing in 2018, tax at top marginal tax rates may apply to dividends paid directly or indirectly through a family trust to an adult. Previously this tax burden or what was commonly called “kiddie tax” applied to dividends paid on private corporation shares to a minor directly or indirectly from a family trust.

What now is called split income or split portion, the basis of this taxation will now include capital gains arising on the disposition of private corporation shares held by minors and by adults, held directly or indirectly from a family trust, as well as to income earned on split income to those ages 18-24.

The capital gains exemption (“CGE”) that would otherwise be available on the sale qualified small business corporation shares (“QSBC”) to the vendor or to the trust beneficiary may also be denied. Prior to 2018, one could allocate the capital gain realized in the trust to any discretionary beneficiary regardless of age and therefore multiply the CGE times the number of beneficiaries. Commencing in 2018, for purposes of the CGE, the value accrued while the vendor was a minor is excluded from the portion otherwise eligible for the CGE.

Generally speaking, the new rules will apply if the recipient was not active in the business, the amount paid exceeds a prescribed rate of return or the recipient did not assume sufficient risk. The active business test is tighter for those older than age 17 and younger than age 25. This is CRA’s concept of a reasonable test that presently lacks sufficient guidance on how to interpret and to implement it.

With respect to dividends, any type of shareholding could be affected, even common shares or special/ preferred shares that were issued as part of an estate freeze years earlier, where in most cases, the shareholder is no longer active in the business.

For those potentially affect by this high rate tax commencing in 2018, one may consider paying additional dividends by the end of 2017 to get them up to the top tax bracket.

There is a special 2018 election where one may bump the basis of the shares to fair market value as at the date of the election selected at any time in 2018, using the pre-2018 rules. The shares must be QSBC shares which means that at the date of the election, 90% of the fair market value of the assets must be used in an active business carried on in Canada, and during the preceding 12 months, a 50% test in lieu of 90% must be met. For normal sales the 12 months is 24 months. If the election is contemplated say for December 31, 2018, the CCPC must meet the 50% test by the end of this year which not a lot of time to purify the corporation of non-active assets such as a passive investment and excess cash not required for working capital.

The election should be considered where there is significant unrealized appreciation in the shares and of course if it is anticipated that the corporation may not be a QSBC in a future year, regardless if the shares are owned directly or held by a family trust. Valuations may be considered here.

The election is not available for minors unless there is an actual disposition in 2018.

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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.
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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.
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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.
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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.

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