2021-0922301I7 Art. XIII(7) Canada -US Treaty and Trusts

Principal Issues: 1. Whether a Canadian resident Trust that owns real property ("U.S. Real Property") situated in the United States ("U.S.") is eligible to make an election pursuant to paragraph 7 of Article XIII (“Art. XIII(7)”) of the Canada-U.S. Income Tax Convention (“Treaty”) to elect for U.S. federal income tax purposes, a notional sale and repurchase of the U.S. Real Property (in the same year Trust will be subject to the deemed disposition pursuant to paragraph 104(4)(b) of the Act)? 2. Whether the Trust could benefit for relief for double taxation pursuant to paragraph 2 of Article XXIV (“Art. XXIV(2)”) of the Treaty in the event the Trust cannot avail itself of the election in Art. XIII(7) of the Treaty and disposes of the U.S. Real Property in a year that is not the same as the year of the Deemed Disposition (pursuant to paragraph 104(4)(b) of the Act).

Position: 1. Cannot be determined by the Canada Revenue Agency as this issue is within the jurisdiction of the U.S. Internal Revenue Service. 2. Relief from double taxation is not available pursuant to Art. XXIV(2)(a) of the Treaty where the year of the Deemed Disposition by the Trust is not the same as the year where, for U.S. income tax purposes, the Trust is considered to have disposed of the U.S. Real Property.

Reasons: 1. It is not within the jurisdiction of the Canada Revenue Agency or the Canadian Competent Authority to determine whether the Trust is eligible to make an election pursuant to Art XIII(7) of the Treaty under the circumstances. Such determination must be made by the U.S. Internal Revenue Service as it would relate to a notional sale and repurchase of the U.S. Property for U.S. federal income tax purposes. 2. The relief from double taxation provided in Art. XXIV(2) of the Treaty is subject to the limitations imposed by subsection 126(1) of the Act.

Author: Argento, Angelina
Section: Article XIII(7), Article XXIV(2)(a) and Article XXIV(3)(a) of the Canada-United States Income Tax Convention and section 126 Income Tax Act

                                                                                       February 3, 2022

Melanie Beaulieu,                                                           HEADQUARTERS
Financial Industries and Trusts Division                         Income Tax Rulings
Income Tax Rulings Directorate                                      Directorate

                                                                                        Angelina Argento
                                                                                        514-277-5798

                                                                                       2021-092230

Subject: Canadian trust, U.S. real property, and a 104(4)(b) deemed disposition

Unless otherwise indicated, all statutory references in this memo are to the relevant provision of the Income Tax Act, R.S.C. 1985 (5th Supp.), c.1, as amended.

This is in reply to your email request of December 23, 2021 and further to our subsequent discussion wherein you informed us that a Canadian resident Trust (“Trust”) that owns real property (“U.S. Real Property”) situated in the United States (“U.S.”) will, pursuant to paragraph 104(4)(b), be deemed to have disposed of the U.S. Real Property on the Trust’s 21st anniversary date (“Deemed Disposition”), resulting in a capital gain. Therefore, the Trust will be liable for Canadian income taxes on the capital gain realized on the U.S. Real Property in the year of the Deemed Disposition.

You ask us to determine whether the Trust is eligible to make an election pursuant to paragraph 7 of Article XIII (“Art. XIII(7)”) of the Canada-U.S. Income Tax Convention (“Treaty”) to elect for U.S. federal income tax purposes, a notional sale and repurchase of the U.S. Real Property to occur in the same year as the year of the Deemed Disposition.

In the event the Trust cannot avail itself of the election in Art. XIII(7) and disposes of the U.S. Real Property in a year that is not the same as the year of the Deemed Disposition (pursuant to paragraph 104(4)(b)), you ask us to determine whether the Trust would benefit for relief for double taxation pursuant to subparagraph 2 of Article XXIV of the Treaty (“Art. XXIV(2)(a)”).

For the purposes of this discussion, we assume that the U.S. Real Property is held by the Trust on account of capital (and not on account of income).

EXECUTIVE SUMMARY

It is not within the jurisdiction of the Canada Revenue Agency or the Canadian Competent Authority to determine whether the Trust is eligible to make an election pursuant to Art. XIII(7) to elect for U.S. federal income tax purposes, a notional sale and repurchase of the U.S. Real Property (in the same year Trust will be subject to the deemed disposition pursuant to paragraph 104(4)(b)). Such determination is within the jurisdiction of the U.S. Internal Revenue Service (“IRS”).

The relief from double taxation provided in Art. XXIV(2) is subject to the limitations imposed by subsection 126(1). Accordingly, where the year of the Deemed Disposition by the Trust is not the same as the year where, for U.S. income tax purposes, the Trust is considered to have disposed of the U.S. Real Property, relief from double taxation is not available pursuant to Art. XXIV(2)(a).

Our Comments

Election under Art. XIII(7)

In the absence of a disposition of the U.S. Real Property by the Trust prior to the date of the Deemed Disposition, the Trust will be liable for Canadian income taxes on the capital gain realized on the U.S. Real Property in the year of the Deemed Disposition. If, the Trust is not eligible to make an election pursuant to Art. XIII(7) in the year of the Deemed Disposition, the U.S. would maintain its right (by virtue of Art. XIII) to tax the Trust on any capital gain realized on the U.S. Real Property only in the year there is a disposition, for U.S. income tax purposes, of the U.S. Real Property.

The mismatching of income and income taxes (in respect of the capital gain resulting from the deemed disposition of the U.S. Real Property) between Canada and the U.S. may result in the potential for unrelieved double taxation if the Trust is unable to obtain a foreign tax credit under subsection 126(1) for the amount of U.S. income taxes paid. In other words, unrelieved double taxation may result if firstly, for U.S. income tax purposes, the disposition of the U.S. Real Property does not occur in the same year as the year of the Deemed Disposition, and secondly, in the year the U.S. Real Property is disposed for U.S. income tax purposes the Trust has insufficient income from other sources in the U.S. to fully utilize the foreign tax credit under subsection 126(1).

The election by the Trust pursuant to Art. XIII(7) would allow a matching of the U.S. and Canadian income taxes paid by the Trust in respect of the U.S. Real Property for foreign tax credit purposes, as the Trust would be subject to U.S. income tax on the capital gain arising in respect of the U.S. Real Property in the same year and on essentially the same basis as it is subject to Canadian income tax.

It is not within the jurisdiction of the Canada Revenue Agency Income Tax Rulings Directorate or the Canadian Competent Authority to determine whether the Trust is eligible to make the election under Art. XIII(7) to accelerate the disposition of the U.S. Real Property (to the year of the Deemed Disposition) for U.S. income tax purposes. Such determination is within the jurisdiction of the IRS.

Subsection 126(1)

The Trust is generally entitled to a foreign tax credit pursuant to subsection 126(1) where the Trust is subject to an income or profits tax paid to the U.S. on the disposition of the U.S. Real Property. In other words, the Trust can claim a foreign tax credit only for the foreign (in this case U.S.) taxes it pays and the actual amount of the foreign tax credit would be determined based on the computational rules of section 126. The CRA’s position is that taxes are considered paid by a taxpayer only if the taxpayer has an actual liability to pay the tax (see Income Tax Folios S5-F2-C1: Foreign Tax Credit for more information).

In general, the foreign tax credit (which is a deduction against Canadian tax payable) cannot exceed the amount of Canadian tax that is payable in respect of the sale of the U.S. Real Property. As noted above, if the Trust pays tax in the U.S. on the capital gain arising from the disposition of the U.S. Real Property but does not have sufficient U.S. source income on which the Canadian tax is otherwise payable in that taxation year, no foreign tax credit is available under subsection 126(1). Moreover, subsection 126(1) does not permit the foreign taxes paid for a particular taxation year to be carried back to a previous taxation year (for example, the year of the Deemed Disposition for which the Trust paid Canadian taxes on the capital gain in respect of the U.S. Real Property).

Elimination of Double Taxation pursuant to Art. XXIV(2)(a)

As noted above, pursuant to the provisions of Art. XIII, the U.S. has the right to tax the Trust on any capital gain arising in respect of the U.S. Real Property in the year there is a disposition for U.S. income tax purposes. Furthermore, subparagraph 3(a) of Article XXIV of the Treaty provides that gains of a resident of Canada which may be taxed in the U.S. in accordance with the Treaty shall be deemed to arise in the U.S. for purposes of Art. XXIV.

Art. XXIV(2)(a) provides that in order to avoid double taxation, income tax paid or accrued to the U.S. on profits, income or gains arising in the U.S. shall be deducted from any Canadian tax payable in respect of such profits, income or gains. The application of Art. XXIV(2)(a) is expressly stated as being “subject to the provisions of the law of Canada regarding the deduction from tax payable in Canada of tax paid in a territory outside Canada and to any subsequent modification of those provisions (which shall not affect the general principle of (Art. XXIV))”. In our view this means that a Canadian resident is subject to the limitations on claiming a foreign tax credit found in the Canadian legislation, and more specifically in section 126, including a timing restriction on when a foreign tax credit may be claimed (see CRA Document 2015-0601781E5 dated May 5, 2017 (Ina Eroff)).

This approach is consistent with the commentary provided by the Organization for Economic Co-operation and Development ("OECD") on Article 23B of the OECD Model Tax Convention on Income and on Capital, 2017 (the "Model Tax Convention"), which requires the state of residence to provide relief from double taxation by granting a tax credit for the taxes levied by the state of source on profits earned in that state. In particular, the OECD states that it is preferable for the credit method in Article 23B not to propose an express and uniform solution in the Model Tax Convention, but to leave each state free to apply its own legislation and technique. The OECD expressly contemplates that states may impose timing restrictions on claiming foreign tax credits. In paragraph 32.8, section F "Timing Mismatch" of the commentary on Article 23 B of the Model Tax Convention it is stated:

[…] Some States, however, do not follow the wording of Article 23 A or 23 B in their bilateral conventions and link the relief of double taxation that they give under tax conventions to what is provided under their domestic laws. These countries, however, would be expected to seek other ways (the mutual agreement procedure, for example) to relieve the double taxation which might otherwise arise in cases where the State of source levies tax in a different taxation year.

In the case of Canada, such "other ways … to relieve the double taxation" include deductions allowed under subsections 20(11) and 20(12). As such, in our view, the limits imposed by subsection 126(1) on claiming a foreign tax credit are in accordance with the OECD guidelines and do not affect the general principle of Art. XXIV.

As a result, if the Trust were to be permitted by the U.S. IRS to make the election under Art. XIII(7) to be treated, for U.S. tax purposes as having disposed and acquired the U.S. Real Property in the same year the Deemed Disposition occurred (pursuant to paragraph 104(4)(b)), Canada would pursuant to Art. XXIV(2) alleviate any potential double taxation but only within the limits governed by subsection 126(1).

However, where the election under Art. XIII(7) is not available to the Trust and the year of the Deemed Disposition by the Trust (pursuant to paragraph 104(4)(b)) does not occur in the same year where, for U.S. income tax purposes, the Trust is considered to have disposed of the U.S. Real Property, the Trust may not obtain a foreign tax credit in Canada for the U.S. taxes paid in a year subsequent to the year of the Deemed Disposition (assuming the Trust has insufficient income from other sources in the U.S. in the year the U.S. Property is considered by U.S. income tax laws to have been disposed), resulting in the potential for double taxation for which no relief is available under the Treaty.

We trust the above information will assist you.

Yours truly,

Marie-Claude Routhier
Section Manager
for Division Director
(International)
Income Tax Rulings Directorate
Legislation Policy and Regulatory Affairs Branch

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