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The 2004 Federal Budget proposes significant changes to the income tax treatment of non-residents who hold units of mutual fund trusts and shares of mutual fund corporations.  The purpose of these changes is to subject non-residents who invest in "taxable Canadian property" ("TCP") indirectly through a mutual fund to Canadian tax in a manner similar to non-residents who invest in TCP directly.  As a result of these new rules, fund managers will be required to closely monitor distributions and dividends paid to non-residents and to comply with a new withholding and reporting regime.

CAPITAL GAINS FROM TCP

A non-resident of Canada is subject to Canadian tax in certain limited circumstances, including upon the disposition of TCP.  The types of property that are considered TCP include real property situated in Canada, shares of private Canadian corporations, interests in a partnership that derives its value primarily from TCP and units of a trust other than a mutual fund trust.  Canada's bilateral tax treaties usually reserve to Canada the right to tax gains of non-residents from the sale of TCP, with certain limited exceptions (e.g. on the sale of private company shares that do not derive their value primarily from real property situated in Canada).

Units of a mutual fund trust and shares of a mutual fund corporation that are listed on a prescribed stock exchange are not TCP unless the non-resident holder, alone or together with persons with whom the holder does not deal at arm's length, owns at least 25% of the outstanding units of the trust or shares of the corporation.  To qualify as a mutual fund trust or mutual fund corporation for these purposes, the fund must have at least 150 unit or share holders.  Consequently, non-residents are rarely taxable in Canada on gains from the sale of units or shares of large mutual funds.  This permits non-residents to invest indirectly in TCP through a mutual fund trust or mutual fund corporation without paying Canadian tax that would have been payable had the investment in TCP been made directly.  For example, non-residents holding REIT units are generally not subject to Canadian tax on gains from the sale of their units.  However, tax would be payable by a non-resident on gains from the direct sale of Canadian real property.  In addition, non-residents are not currently subject to Canadian withholding tax on distributions of capital gains out of a mutual fund trust or on capital dividends paid by a mutual fund corporation.

To reduce the disparity between these two methods of investing in TCP, the Budget proposes to subject non-residents to a 25% withholding tax on distributions of capital gains out of a mutual fund trust and on capital gains dividends paid by a mutual fund corporation, to the extent that such gains are derived from the disposition of TCP after March 22, 2004.  The rate of withholding will generally be reduced to 15% under most of Canada's bilateral tax treaties.  Every mutual fund trust and mutual fund corporation will be required to maintain a "TCP gains distributions account" and to track the payment of "TCP gains distributions" to non-residents.  Additional compliance requirements will include making the appropriate withholdings from distributions or dividends, making timely remittances of tax, preparing tax reporting slips for non-resident investors and filing information returns disclosing the amount of tax withheld and remitted.

WITHHOLDING TAX ON OTHERWISE NON-TAXABLE DISTRIBUTIONS

The Budget proposes to impose a new 15% tax on non-residents receiving otherwise non-taxable distributions after March 22, 2004 on units of a mutual fund trust or shares of a mutual fund corporation that are listed on a prescribed stock exchange, where the value of the units or shares is primarily attributable to real property in Canada, Canadian resource property or timber resource property.  In essence, this tax will apply to returns of capital and capital gains distributed by such mutual funds to a non-resident investor.  The tax will not apply to distributions that are taxable as "TCP gains distributions" (discussed above) or to any other distributions on which non-residents are currently subject to Canadian tax.  Mutual funds will be required to make withholdings and remittances in respect of this tax.

This tax will apply to distributions made by REITs and certain resource based income trusts, but not to "business" income trusts that do not hold portfolios of real property or resource properties.

If a non-resident has paid this new tax and subsequently realizes a loss on the disposition of a unit or share of the mutual fund that paid the distribution, the non-resident will be permitted to file a special Canadian tax return.  In that return, the non-resident can apply the loss to previous distributions paid to the non-resident on that unit or share or to reduce distributions on other units or shares held by the non-resident that have also been subject to this new tax on distributions.  This will permit the non-resident to claim a refund of all or part of the tax previously withheld.  Any unused losses may be carried back three taxation years and carried forward indefinitely.  These losses may not be used for any purpose other than to offset this new tax.

INVESTMENTS IN RESOURCE PROPERTIES

A mutual fund trust or a mutual fund corporation that has been established or maintained primarily for the benefit of non-residents is required to restrict its holdings of TCP at all times to 10% or less of the total value of all of its property.  Failure to abide by this restriction can result in a loss of mutual fund trust or mutual fund corporation status.  Canadian resource property and timber resource property are not currently TCP for purposes of this restriction.  Consequently, a fund could be maintained primarily for the benefit of non-residents and not be required to restrict its holdings of such properties to the 10% threshold.

The Budget proposes to eliminate this benefit by deeming Canadian resource property and timber resource property to be TCP for these purposes.  This amendment will apply after March 22, 2004, but transitional relief will be provided for funds that are currently mutual fund trusts or mutual fund corporations but would immediately lose their status if, as a result of this amendment, they would hold an excessive amount of TCP.  Such funds will have until the end of 2006 to comply.

INFORMATION REPORTING

The Budget proposes to require a trust to identify the portion, if any, of its distributions to a beneficiary that give rise to an adjustment in the adjusted cost base of the beneficiary's interest in the trust.  Beginning in its 2004 taxation year, a trust will be required to issue an information slip to its beneficiaries containing this information.  It appears from the language of the Budget documents that this measure will apply to all trust distributions, whether or not the trust qualifies for mutual fund trust status.  This may have been unintentional, in which case the Department of Finance would be expected to clarify that this measure is only intended to apply to mutual fund trusts.

The purpose of this document is to provide information as to developments in the law.  It does not contain a full analysis of the law nor does it constitute an opinion of Ogilvy Renault or any member of the Firm on the points of law discussed.

©OGILVY RENAULT 2004 - All Rights Reserved

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