Introduction: Investing in Canadian Real Property by Foreign Investors
Canada’s relatively stable economy coupled with its booming real estate market is attractive to many foreign investors. To help inform the structure of their investments, foreign investors seeking to invest in Canadian real estate should be aware of their reporting obligations and the tax rules under the Canadian Income Tax Act. This article will address the reporting obligations for non-residents earning rental income from Canadian real property, the application of Part XIII withholding tax, election under subsection 216(1) of the Income Tax Act, and compliance obligations under section 116 of the Income Tax Act upon the sale of Canadian real property.
Background on Part I and Part XIII Taxes
Under the Canadian tax regime, liability for tax is based on residence and source. For non-residents, the basis of their liability for Canadian tax is dependent upon their Canadian-source income. Accordingly, two main categories of taxes may apply to non-residents: Part I and Part XIII taxes. Part I tax applies to non-resident if they are: (i) employed in Canada, (ii) carries on business in Canada, or (iii) disposes of taxable Canadian property. For non-residents who are not labile for Part I tax, Part XIII tax may apply if the non-resident earns other types of Canadian-source income, namely passive income, such as interest, dividends, management fees, rents, royalties, and pensions (for a more comprehensive list, please refer to subsections 212(1) and 212(2) of the Income Tax Act). Since Part XIII tax is a source-based tax, this tax applies to gross income as opposed to net income, and the payer (i.e., tenant or agent) is responsible for withholding and remitting the tax to the federal government. Absent an exemption or a provision that reduces the rate in a tax treaty between Canada and the non-resident’s country of residence, the default withholding tax rate is 25% of the gross income.
For non-residents who earn rental income, the tax implications depend on the characterization of the rental income itself. Thus, the starting point is a fact-driven analysis to discern whether the rental income is considered business or property income.
For non-resident investors who earn rental income that is considered property income, such rental income is subject to the default withholding tax rate of 25% on the gross rental income. However, this can be changed by filing a section 216 election as discussed below. No reduction for expenses or depreciation is permitted. For non-resident investors who earn rental income from carrying on a business, the investor will also be liable for Part I tax. Since the investor is liable for Part I tax, the investor is eligible for the carryover rules under section 111 of the Income Tax Act. This means that business losses incurred from the rental business can be carried forward twenty years or back three years. Further, if the non-resident investor owns multiple business properties in Canada, the losses incurred by one property can be applied to offset the net income arising from another property in calculating the overall income and taxable income of the investor for Canadian tax purposes. Since there may be a potential for double taxation, the non-resident investor may be exempt from Part XIII withholding tax if the income is attributable to business carried on by the non-resident through a permanent resident as provided by section 805 of the Regulations to the Income Tax Act.
Moreover, as mentioned above, the payer, either the tenant or the agent (e.g., the property manager), is responsible for withholding and remitting the non-resident tax of 25% on the gross rental income earned by the non-resident. The payer must remit the withholding tax to the Canada Revenue Agency (CRA) on or before the 15th day of the month following the month the rental income is paid or credited to the non-resident. Failure of the payer to remit may lead to the payer incurring compound daily interest on the amount not withheld and being charged with a penalty.
Election under Subsection 216(1) of the Income Tax Act
If the investor’s property is a non-business property, the investor should consider making an election under subsection 216(1), which permits the investor to pay tax on the net rental income as opposed to the gross rental income. Such an election is beneficial and almost always advisable as the non-resident can compute tax liability by deducting rental expenses against gross rental income, which will typically lead to a lower tax payable.
Apart from filing a non-resident tax return (Form 5013-R T1) for the rental income, non-residents who make an election under subsection 216(1) are also required to file a separate return known as Form T1159 within the end of the second year in which the rental income was earned. When this occurs, the non-resident pays an upfront 25% withholding tax, but can apply for a refund thereafter based on the tax payable on a net basis. To bypass having to pay first and seeking a refund afterwards, the non-resident investor can request that the property manager make an election under subsection 216(4) by filing Form NR6. When this occurs, a withholding tax rate of 25% is applied against net income. Investors seeking to make a subsection 216(4) election should be mindful that the election should be filed with the CRA within six months after the end of the year a tax return under Part I of the Act should be filed.
If a subsection 216(1) income tax return is not filed on time, typically, the election will be considered invalid. However, based upon CRA’s late filing policy for a subsection 216(1) election, non-residents may have a second chance to file a return and correct withholding and filing deficiencies if:
- The CRA has not notified you of your obligations under Part XIII of the Income Tax Act in relation to reporting your rental income;
- The CRA has not commenced an action due to your failure to comply with Part XIII; or
- You have not submitted Form NR6 and the CRA has not approved.
For non-resident investors who file their subsection 216(1) late, the CRA will not apply penalties, but it may charge interest arrears for any Part XIII taxes that were not withheld and remitted, and for any outstanding tax liability under Part XIII of the Income Tax Act.
Tax Obligations under Section 116 of the Income Tax Act
At some point, the non-resident may want to sell the rental property. What happens then? Under section 116 of the Income Tax Act, the non-resident is required to obtain a clearance certificate or so-called certificate of compliance. Since the federal government has no direct authority over the non-resident vendor, section 116 ensures that the federal government can collect tax on capital gains from the sale of Canadian real property by non-residents.
To obtain a clearance certificate, the non-resident must first notify the CRA of the disposition either within 10 days of the sale or before the sale is intended to take place. If the vendor notifies the CRA before the sale is intended to take place, the vendor must also provide the CRA with acceptable security for the CRA to issue a certificate of compliance. If, however, the vendor is unable to provide the purchaser with the clearance certificate upon closing, the responsibility falls on the purchaser to withhold and remit 25% from the purchase price to the CRA
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."