Editor’s Note: The information below isn’t exhaustive of all possible US income tax considerations nor is it intended to provide legal or tax advice to any particular holder or potential holder of Canadian income or royalty trust units or common stock of Canadian corporations. Holders or potential holders of Canadian income or royalty trust units or common stock of Canada-based corporations should consult their own competent legal and tax advisers as to their particular tax consequences of holding Canadian income or royalty trust units or common stock issued by Canada-based corporations and the most beneficial way of reporting the distributions or dividends received and Canadian withholding tax paid to the appropriate taxation authorities located in the various jurisdictions.

What was simply a blind spot at the intersection of Canadian and American tax law has to be the longest-running

Back in 2004 the Canadian government did not consider “income trusts,” “income funds ” or “royalty trusts” or any other organization that eventually fell within the meaning of the “Specified Investment Flow-Through” definition for purposes of new taxation as a “corporation” within the meaning of its tax code.

This meant that, on the Canadian side of the border, “distributions” paid by income trusts, et. al., were not considered “dividends” paid by “corporations” within the meaning of the then-extant Convention Between the United States of American and Canada with Respect to Taxes on Income and Capital (the Treaty) and were therefore subject to 25 percent withholding based on Canadian law.

Meanwhile, after some controversy, it was generally resolved that Canadian income trusts were, for the most part, “corporations” whose “distributions” were “qualified” within the meaning of US tax law. There was a corrective measure on the US side of the border for investors who held Canadian income trusts in a regular, taxable account to recover or be credited for amounts paid in excess to Canadian tax authorities.

There was not, however, a mechanism to correct the situation where Canadian authorities, acting within the meaning of Canadian law, withheld 25 percent from distributions paid by a Canadian income trust in respect of units held within a US IRA account. Keep in mind that this 25 percent would have been withheld from the same distribution paid to a Canadian resident.

The problem of “improper” withholding from “distributions” (in Canada) or “dividends” (in the US) cropped up because there simply was no mechanism or form created in contemplation of such a process for what is a tax-deferred account and is separate from the beneficiaries “tax identity.” You’ll be taxed when you take distributions from your IRA under normal procedures, identified via a taxpayer identification number or a Social Security number.

IRS Form 1116, which provides for US tax credit for amounts paid to foreign governments, does not allow an individual to claim amounts “improperly” withheld from an IRA account of which he or she is the beneficiary.

US-Canada Income Tax

Theoretically, by operation of the Fifth Protocol to the US-Canada Income Tax Treaty and supporting materials, dividends paid by basically all Canadian companies that pay entity-level tax will be considered “qualified” for US tax purposes.

Qualified v. Not Qualified

These issues are resolved–on a trust-by-trust basis–once a trust’s conversion to corporate status is complete. Dividends paid by Canadian corporations are, generally, qualified. Circumstances where this is not the case are rare, particularly in the CE coverage universe.

In the US, the 2003 Jobs Growth and Tax Relief Reconciliation Act (the 2003 Act) established that a dividend paid to an individual shareholder from either a domestic corporation or a “qualified foreign corporation” is subject to tax at the reduced rates applicable to certain capital gains, in most cases 15 percent. This lower rate was extended for two years, through 2012, and will be an issue in the November election.

A “qualified foreign corporation” includes certain foreign corporations that are eligible for benefits of a comprehensive income tax treaty with the US.

If the Canadian trust or corporation is listed on the New York Stock Exchange (NYSE), it’s dividend is probably qualified because of the Treasury Dept’s “readily tradable” test: “A foreign corporation not otherwise treated as a qualified foreign corporation is so treated with respect to any dividend it pays if the stock with respect to which it pays such dividend is readily tradable on an established securities market in the US.”

Not qualified according to the 2003 Act is any entity that can be classified as a passive foreign investment company (PFIC). This is a fact-sensitive determination that can only be made on a year-by-year basis after all the beans have been counted.

Within the meaning of the 2003 Act, a non-US entity treated as a corporation for US federal tax purposes is a PFIC if in any given taxable year if either: at least 75 percent of its gross income is “passive”; or at least 50 percent of the average value of its assets is attributable to assets that produce passive income or are held for the production of passive income. For the most part, however, the trusts and corporations recommended in the Portfolios and covered in How They Rate are operating businesses.

You can report distributions paid by a Canadian trust in 2010 as qualified if: the trust has made a public statement to the effect that the units “will be, should be or more likely than not will be” treated as equity rather than debt for US federal income tax purpose; and, the security is considered “readily tradable on an established securities market in the US” or “the foreign corporation is organized in a country whose income tax treaty with the US is comprehensive….”

CE has provided links to statements issued by income trusts in its coverage universe in the Income Trust Tax Guide; these statements typically include language along the lines of the following:

In consultation with its US tax advisors, TrustCo believes that its trust units should be properly classified as equity in a corporation, rather than debt, and that dividends paid to individual US unitholders should be “qualified dividends” for US federal income tax purposes.

As such, the portion of the distributions made during 2008 that are considered dividends for US federal income tax purposes should qualify for the reduced rate of tax applicable to long-term capital gains. However, the individual taxpayer’s situation must be considered before making this determination.

Of course, any trust or corporation listed on the New York Stock Exchange is readily tradable. As for those issues traded on the US over-the-counter (OTC) market, the final piece of the “qualified” equation is provided by the United States-Canada Income Tax Convention.

Review 1099s from your broker carefully. Check out individual trusts’ statements on the US tax status of their distributions. The best source of information–as indicated by the willingness of the IRS to rely on the tax status interpretation of the trusts–is the particular trust. We’ve heard many stories of CE subscribers successfully dealing with their brokerage firms on this issue.

If there’s no statement published on a website, contact the investor relations (IR) representative of the particular income trust via e-mail or phone. If the Web statement or your contact with IR reveals the trust believes its distributions to be qualified–it’s best to get it in writing–give this information to your broker.

Use the Qualified Dividends and Capital Gain Tax Worksheet of Form 1040 to determine the amount of tax that may be applicable.

The bottom line is this: The IRS will waive penalties with respect to reporting of payments if individuals required to file Form 1099-DIV make a good faith effort to report payments consistent with the law.

IRAs

It’s a general rule of US federal taxation that an individual isn’t liable for US taxes on amounts earned through an IRA until those amounts are distributed. But US tax law can only defer US tax. US tax authorities have no power to influence a foreign country’s imposition of tax on income that the IRA derives from that country.

Distributions from Canadian income and royalty trusts therefore may be subject to tax in Canada depending on Canadian tax law and the terms of the US-Canada Income Tax Treaty (the Treaty).

Certain US entities that are generally exempt from taxation in a taxable year in the US–such as IRAs–are exempt from taxation on dividend income arising in Canada in that same taxable year, according to Article XXI of the Treaty, “Exempt Organizations.”

Based on a 2005 change in Canadian tax law, Canada began imposing a 15 percent withholding tax on distributions from income and royalty trusts to US residents. Canadian tax law didn’t initially treat these distributions as dividends, however, and so they weren’t exempt from Canadian tax under Article XXI of the Treaty.

In 2007, Canada amended its domestic law again and began taxing certain of these trusts as corporations and treating distributions from these trusts as dividends for purposes of both their domestic law and their tax treaties.

Canada and the US signed an exchange of diplomatic notes in 2007, on the same day the two parties signed the Fifth Protocol to the Treaty, that include what we’ve often referred to as “Annex B.” These notes confirmed, among other things, “that distributions from Canadian income trusts and royalty trusts that are treated as dividends under the taxation laws of Canada shall be considered dividends for the purposes of [the Treaty].”

However, Canadian law–the Tax Fairness Act–provided that Canada would begin taxing income and royalty trusts already in existence as of Oct. 31, 2006, as corporations on Jan. 1, 2011. Up to that date Canadian tax law didn’t treat distributions from such trusts as dividends. Distributions from these pre-existing trusts should be exempt from Canadian tax under Article XXI of the treaty as of Jan. 1, 2011, when these income and royalty trusts became “Specified Investment Flow-Throughs,” or SIFTs, taxed at the entity level.

The IRS has acknowledged that investors who hold Canadian trust units in IRAs may not claim a foreign tax credit for the Canadian taxes withheld on the income paid in respect of those units. This is consistent with a general rule that foreign tax credits may not be credited against an individual’s tax liability unless the individual is liable for the tax. Nor can the IRA make use of a foreign tax credit because it’s exempt from tax in the US.

This may ultimately result in double taxation when the IRA distributes this income to the unitholder.