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.

The curtain has closed on the 2010 filing year for most tax payers, and along with it major operations on the long battle for cross-border tax clarity. 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.

There are steps to take to claw back amounts improperly withheld from distributions made in respect of shares/units held in US IRA accounts, but progress is slowly being made.

Qualified v. Not Qualified

This issue is 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 recently extended for two years, through 2012.

A “qualified foreign corporation” includes certain foreign corporations that are eligible for benefits of a comprehensive income tax treaty with the US, which the Secretary determines is satisfactory for purposes of this provision and that includes an exchange of information program.

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

In the December 2010 Canadian Edge we advised–via headline, no less, as well as in that issue’s Tips on Trusts–to choose Schwab for proper treatment of withholding from distributions/dividends paid by income trusts, SIFTs and converted trusts now operating as corporations. We regret that we were overzealous in our endorsement. Though we acted then on information received from multiple subscribers, we have since gotten word that Schwab’s official policy remains to withhold from amounts paid to US IRAs, without regard to changes wrought by the Fifth Protocol to the US-Canada Income Tax Convention and explanatory documents.

Our inquiries into the reason for the contradictory anecdotal evidence about treatment of distributions from SIFTs and former Canadian income trusts that have converted to corporations made in respect of units or shares held in US IRAs have revealed a “culprit,” and it’s Citigroup (NYSE: C), which, through an affiliated clearing corporation, continues to improperly withhold. SIFTs and converted corporations that clear through the Depositary Trust Company (DTC) are, according to several brokerage-house back offices, being properly handled. Dividends paid by Atlantic Power Corp (TSX: ATP, NYSE: AT), for example, which clears through DTC, are being handled properly. On the other hand, Citigroup handles Colabor Group’s (TSX: GCL, OTC: COLFF) dividends, and US investors who hold it in an IRA have been getting the shaft since Colabor started paying entity-level taxes in 2007.

One way to pursue relief is to write a letter to the Canada Revenue Agency (CRA), the Great White Northern equivalent of our Internal Revenue Service (IRS), to request a Letter of Exemption under Article XXI of the US-Canada Income Tax Treaty. Your brokerage, as the custodian of the relevant account–the IRA of which you are the beneficiary–should write this letter, but this is one of the onerous service it’s refusing to engage in on your behalf.

Include your name, the name of your brokerage, the account number of the IRA, and an explanation of why there should be no withholding from dividends paid by Canadian SIFTs and Canadian corporations that converted from income trusts in respect of units or shares held in a US IRA account.

The argument, articulated here before and based on the contents of a letter to US Representative Phil Gingrey (R-GA) signed by Elizabeth U. Karzon, Branch Chief, Branch 1, Office of Associate Chief Counsel (International), US Dept of the Treasury, Internal Revenue Service, dated June 17, 2010, is as follows.

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–provides that Canada won’t tax income and royalty trusts already in existence as of Oct. 31, 2006, as corporations until Jan. 1, 2011. Until then, Canadian tax law won’t treat distributions from such trusts as dividends. Distributions from these pre-existing trusts won’t be exempt from Canadian tax under Article XXI of the treaty until 2011–when these income and royalty trusts will become “Specified Investment Flow-Throughs,” or SIFTs, taxed at the entity level.

The IRS acknowledges 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. The 2007 Tax Fairness Act, when it and the Fifth Protocol have full effect, will generally eliminate the 15 percent Canadian withholding tax on dividends paid by income and royalty trusts in respect of units held in US IRAs.

It may be helpful to attach to your letter a copy of Karzon’s letter to Rep. Gingrey; I’m happy to provide a pdf copy to anyone who requests it via e-mail to ddittman@kci-com.com.

Once the Letter of Exemption is issued you–or your broker–on behalf of your IRA must inform the transfer agent of the Canadian SIFT or former income trust that’s now a corporation from withholding for Canadian tax purposes.

The address for the Canada Revenue Agency is:

Non-Resident Withholding Accounts Division
International Tax Services Office
Canada Revenue Agency
2204 Walkley Road
Ottawa, ON
K1A 1A8
Canada

You can also call the CRA at 1-800-267-3395 or 1-613-952-2344. The fax number is 1-613-941-6905.

You should copy Citigroup as well as the company that’s paying your dividends.  Citigroup’s Global Transaction Services unit can be reached through an online form; our attempts to speak to someone in authority have thus far gone unrewarded. Contact information for your holdings is available on company websites, accessible via How They Rate. In addition to attaching a copy of the Karzon letter to your correspondence with the CRA, Citigroup and your companies, carbon copy your US congressman.

There’s no question this is an uphill battle. You’re likely to be told by the CRA that the brokerage, as the custodian of the IRA, must submit the request. That’s why we’re copying the folks on Capitol Hill. Let’s see, first, how accountable brokerages, transfer agents and government agencies are to self-directed investors and, second, whether the new wave of responsiveness washing over DC results in Congress correcting what should be an easily fixed problem.

Over the past year we’ve advised CE subscribers to use a letter from a US Treasury official explaining the legal consequences of the Fifth Protocol to the Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital, what we commonly refer to as the US-Canada tax treaty.

The basic principal of this and all other treaties like it is to eliminate or reduce double taxation. The US-Canada agreement is particularly clear about its aims to achieve a level of reciprocity on taxation befitting the largest bilateral trade relationship in the world. The so-called Karzon Letter explains that distributions or dividends paid by Canadian income trusts that have either become tax-paying SIFTs (specified investment flow-through) or tax-paying corporations in respect of units or shares held in US IRA accounts should no longer be subject to withholding.

There is no objection to the substance of the law. There is, however, considerable trouble when it comes to enforcement–as in, there is no institutional will to do right by US investors who hold still-standing trusts and converted corporations in IRA accounts. Certain brokerages, Fidelity, notably, are taking the extra step to help high-value clients, but these efforts have not yet resulted in a coordinated effort, for example, by Schwab, E*Trade and other biggies to work with Canadian-side clearing agents and Revenue Canada to make it easy for people to enjoy what is rightfully theirs.

The grassroots letter-writing effort has therefore achieved limited results. As a means of explaining again what remains an alternative and at the same time lighting a fire that may finally reach what should be responsible authorities, here’s a (lightly) abridged version of the process non-residents of Canada can go through to get amounts improperly withheld on the Canadian side of the border back, via the Canada Revenue Agency (CRA) Form NR7-R:

• Only you, as the “beneficial owner,” are entitled to refund, with limited exceptions.
• Where tax was remitted to the CRA in Canadian currency, you must enter the “Refund applied for” in Canadian currency. The CRA will then issue only a Canadian currency refund. You may need to contact the Canadian payer or agent to confirm the remittance currency.
• The CRA will issue refunds in a foreign currency only if the tax was remitted in that same foreign currency. If it approves a refund in foreign funds, it will use the exchange rate that applies on the date we issue the refund check. As a result, the amount refunded may be different from the amount remitted.
• You must verify the “Tax payable” rate to ensure it agrees with the rate provided under Section 212 of the Income Tax Act or with the relevant tax treaty rate provided within Information Circular 76-12R5 (or later) based on the non-resident’s country of residence at the time of payment.
• For security payments, such as dividends or interest, CRA requires one (1) NR7-R application per payable date, per income type, per beneficial owner, per CUSIP number, per Canadian payer or agent’s non-resident tax account number.
• The CRA only issues current year refunds to clients for security payments that flowed through custodians or nominees. Otherwise, you may request a current year refund directly from the Canadian payer or agent where an NR4 slip or Canadian tax slip hasn’t yet been issued.
• The CRA doesn’t issue refunds for less than $2.00.

Emphasis mine. You’re also required to provide a detailed reason for requesting the refund.

• You must provide details of payment and tax withheld.
• You must provide the appropriate “Reason for refund” and any relevant exemption number for the beneficial owner.
• Where there are third-party participants, such as a custodian, the CRA requires a notarized affidavit of beneficial ownership linking the custodian and beneficial owner. The affidavit must include: the name of the beneficial owner of the security, the name of the custodian, the number of units held by the custodian, the name of the security, the payable date of the security and the notary or lawyer’s seal and signature.
• Where there are third party participants, such as a custodian, the CRA also requires a notarized affidavit of registered ownership linking the custodian and the beneficial owner. The affidavit must include: the name of the beneficial owner of the security, the name of the custodian, the number of units held by the custodian, the name of the security, the payable date of the security and the notary or lawyer’s seal and signature.
• If the transaction flowed through the Depository Trust Company (DTC) in the US, an authorized DTC Statement, specifically a Final Detail Report, CSH SDFS Settlement Stmt Div. or Dividend Cash Settlement Items List, are mandatory substitutions for the “affidavit of registered ownership.”

Original, signed NR7-R applications with all required documentation must be sent to the CRA no later than two years after the end of the calendar year in which the non-resident tax was remitted. The address is: International Tax Services Office, Non-Resident Withholding Division, Station T, PO Box 9769, Ottawa ON K1G 3Y4 Canada.

You can reach the CRA’s International Tax Services Office at 1-800-267-3395 (within Canada and the US) or 613-952-2344 (outside North America). You can also fax your applications to 613-941-6905.

What individual investors are asked to do is enforce the law on their own, and it’s a complex, time-consuming process that many simply can’t afford. It’s a joke that they’re put in this position.