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Canadians Selling U.S. Real Estate

As you may be aware of there is a federal 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 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 qualifying for any of the specific legislative FIRPTA withholding exemptions, the tax withholding can be reduced to what the estimate tax would be on the capital gain that is reported on the tax return, but only, by filing IRS form 8288-B application for a withholding certificate by the closing date of the sale with the FIRPTA office of the IRS.

The application requires copies of your sale agreement and your purchase agreement with a schedule supporting the adjusted basis and tax computation. If the property was rental, you need to update your financial information to the date of sale to properly compute the tax. Most renters have “passive activity loss” carry forwards that can be utilized in the computation of the tax payable.

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 usually takes 90 days for the IRS to respond to the 8288-B applicant.

Generally it makes sense not to file application for sales occurring late in the year as one could file the tax return as early as late January in most years and get the refund in due course. Presently it is taking up to 6 months for refunds from filing the non-resident tax returns because the NR returns must be paper-filed and the department appears to be over-loaded with these returns. Therefore, the 8288-B applications should be considered for all cases where there is significant withholding tax.

If you don’t have an ITIN as an individual vendor, you need to apply with the IRS Form W-7 by sending the ITIN application to the ITIN office with your 8288-B application. To speed things up at the FIRPTA office, it is advisable to also send copy of the 8288-B application to the FIRPTA office at the same time, indicating that you have sent in the ITIN application.

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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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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.

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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.

Contact your professional advisor prior to implementing any of the outlined strategies.

Internal Revenue Service Circular 230 Disclosure
Pursuant to Internal Revenue Service Circular 230, we hereby inform you that the advice or information set forth herein with respect to U.S. federal tax issues was not intended or written to be used, and cannot be used, by you or any taxpayer, for the purpose of avoiding any penalties that may be imposed on you or any other person under the Internal Revenue Code.

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OVDP & 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.

This means that the only remaining remedy to avoid certain penalties is to utilize where available, a reasonable cause argument, which could be tougher given the generosity of the IRS with these programs over the last number of years.

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