2016-0634191I7 Income from a U.S. trust

Principal Issues: Whether income allocated by a U.S. trust to a resident of Canada retains its nature as a dividend?

Position: No

Reasons: Subsection 108(5) recharacterizes the income to be income from property that is the interest in the trust.

Author: Thomson, Sherry
Section: 108(5)

                                                                                                March 24, 2016

Ms. Brenda Goyette                                                                HEADQUARTERS
Taxpayer Services Directorate                                                Income Tax Rulings
Assessment, Benefit & Service Branch                                   Directorate
395 Terminal Avenue                                                              S.E. Thomson
Ottawa ON K1A 0L5                                                               (613) 670-9002

                                                                                                2016-063419
Re:  XXXXXXXXXX (the “Taxpayer”)

Dear Ms. Goyette:

Enclosed are documents that were forwarded to us by the XXXXXXXXXX Tax Services Office.  We received them on February 26, 2016; there was no covering letter.  XXXXXXXXXX.

The documents contain a T1 Adjustment Request from the Taxpayer for each of the 2013 and 2014 taxation years.  Based on the covering letter from the Taxpayer, it appears that she thinks that the amounts that she received from a U.S. trust and that she reported on line 121 (interest and other investment income) on her 2013 and 2014 T1’s should have been reported on line 120 (taxable dividends from taxable Canadian corporations), which would entitle her to the dividend tax credit.  We are sending the documents to you because we are unable to process T1 Adjustment Requests in our Directorate.

However, we believe that the Taxpayer’s request should be denied.  In her letter, the Taxpayer has listed several reasons why she believes that she is entitled to the adjustments.  We have reproduced sections of her letter below and provide our comments on each of them.

1.    In XXXXXXXXXX 2011, my aunt died in the US.  She left her money in a charitable trust, with some of the income bequeathed to me annually for the rest of my life.  I will never control, or inherit, one penny of the principal.

The Taxpayer is a beneficiary of a non-resident trust.  Pursuant to paragraph 12(1)(m) and subsection 104(13) of the Income Tax Act (the “Act”), she must include in computing her income for a particular taxation year the portion of the trust’s income for the trust’s taxation year that ended in the particular taxation year that became payable to her in the trust’s year.  For these purposes, subsection 104(24) of the Act defines the word “payable” to mean an amount that was either paid to her in the year, or to which she was entitled to enforce payment in the year.  Pursuant to paragraph 250.1(b) of the Act, the trust’s “income” must be computed according to the rules of the Act.

2.    The Trust income is derived mostly from US dividends.  According to CRA rules, I must claim US dividends as “interest”.

Subsection 108(5) of the Act provides that amounts included in the Taxpayer’s income under subsection 104(13) of the Act shall be deemed to be income from property that is an interest in the trust and not from any other source (unless the Act provides otherwise).  The rules require the Taxpayer to report the income as “income from a trust”; they do not require the Taxpayer to report the income as “interest”.  However, both income from a trust and interest income are considered to be income from property.

3.    The lawyer in XXXXXXXXXX who manages the trust assures me that Canadian dividends are treated by the IRS in exactly the same way that American dividends are treated.  He cannot understand why this is not reciprocal.  Neither can I.

For Canadian tax purposes, the income that the Taxpayer has received is deemed to be income from an interest in a trust; it does not retain its character as dividend income.  If the amount had been a dividend received directly from a corporation (i.e. not through the trust), the dividend (converted to Canadian dollars) must be included in the Taxpayer’s income in the year of receipt whether the dividend had been paid by a Canadian corporation or a foreign corporation.

If the amount is a dividend, and the dividend is a taxable dividend paid by a corporation resident in Canada, the dividend would be “grossed-up” by an additional amount (footnote 1), and the grossed-up dividend would be included in the Taxpayer’s income.  The Taxpayer would also be eligible for a deduction from tax otherwise payable pursuant to section 121 of the Act, commonly referred to as a “dividend tax credit”.  Very generally, the dividend tax credit recognizes that the dividends are paid out of income on which the corporation has already paid Canadian tax.

However, dividends from foreign corporations do not qualify for the dividend tax credit.  Therefore, even if the amount received by the Taxpayer had been considered to be a dividend, she would not have been eligible for the dividend tax credit.

4.    There is a tax treaty, the purpose of which, one would think, would be in part to establish rules for reciprocal treatment on the taxation of cross-border income.  Article X of the Canada-US Tax Treaty governs the taxing of dividends.  There appear to be two versions of Article X’s interpretation – one developed by the IRS and the other by CRA.  The texts are different.  On the surface, it appears that Article X may be applied differently in Canada than in the US.  This could be the reason for the lack of reciprocity of Canada’s tax treatment of US dividend income.

The first document that the Taxpayer has provided is a copy of Article X of the Canada-U.S. Tax Convention (the “Treaty”) as updated by the Third Protocol (1995).  Note that this is not the latest version of the Treaty.  The Treaty was amended by the Fifth Protocol (2007), available at this link: http://www.fin.gc.ca/treaties-conventions/unitedstates-etatunis-eng.asp.  Both Canada and the U.S. have agreed to the same versions of the Treaty as updated by the various Protocols.

The second document that she provided is a copy of the U.S. Treasury Technical Explanation on Article X of the Second Protocol to the Treaty (1984).  The Treaty and the Technical Explanation are two distinct documents; they are not two versions of Article X’s interpretation.  The U.S. Treasury has also released Technical Explanations to the Third (1995), Fourth (1997) and Fifth (2007) Protocols.  In all cases, Canada has stated that the Technical Explanations accurately reflect understandings reached in the course of negotiations with respect to the interpretation and application of the various provisions in the Protocols (footnote 2).  

Paragraph 1 of Article X of the Treaty that is currently in effect (i.e. as updated by the Fifth Protocol) states that dividends paid by a company that is a resident of the U.S. to an individual who is a resident of Canada may be taxed in Canada.  Paragraph 2 of current Article X states that the amount of tax that the U.S. can withhold is limited to 15%.  These paragraphs do not affect how Canada taxes its own residents; that is, the Treaty does not state that Canada is limited to taxing its own residents at 15%.

Furthermore, even if the U.S. considers that income paid from a trust retains its nature as dividend income, Canada does not.  As noted above, in Canada, the income is considered to be income from a property that is an interest in a trust.  The Treaty does not prevent Canada from characterizing the payment as income from a trust.

5.    The issue is extremely important to me personally, as I will receive the trust income for the rest of my life and have been paying > 30% tax on it.

We presume that the Taxpayer means that she is paying more than 30% Canadian tax on this income.  She has attached the U.S. reporting slips (Schedule K-1), but there is nothing on them to indicate that she has paid any U.S. tax on the income.  Therefore, we assume that she means that she is paying tax on the trust income in Canada at her marginal rate, and is not getting the dividend tax credit.  As noted above, this income is not considered to be dividend income for Canadian tax purposes, and even if it were, dividends from foreign corporations are not eligible for the dividend tax credit.

Conclusion

We believe that the Taxpayer correctly reported the income on her 2013 and 2014 T1’s and the request for an adjustment should be denied.

Thank you for your assistance with this file.  If you have further questions, please contact Sherry Thomson at the number above. 

Yours truly,

Julia Belova, Manager
For Director
International Division
Income Tax Rulings Directorate

FOOTNOTES

Note to reader:  Because of our system requirements, the footnotes contained in the original document are shown below instead:

1  Under subsection 82(1) and paragraph 12(1)(j) of the Act.  The amount of the gross-up depends on the taxation year in which the dividend is received, and whether it is an eligible or a non-eligible dividend.  
2  See Department of Finance news releases:  84-128, 95-048, 97-122 and 2008-052.

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