Many Canadian tax-exempt organizations invest in the United States as part of a diversified portfolio. As these investors are exempt from tax in Canada, any US tax paid on the investments is a net cost to them. Thus, eliminating US tax is an important step to maximizing investment returns. This article provides a high-level overview of the US tax exemptions available to Canadian tax-exempt investors, the scope of those exemptions, as well as refund opportunities for prior tax paid. To start out, however, consider why Canadian tax-exempt investors may be paying taxes to the US.

US tax exposure

Under the Canada-US Tax Treaty (“Treaty”), all Canadian resident individuals, corporations or trusts, whether they are tax exempt in Canada or not, are exempt from US tax on interest income from US sources and capital gains on the sale of US stocks. Canadians are, however, subject to a 15% tax on dividends from US stocks as well as tax on the sale or rental of US real property. It is these two categories of taxes that Canadian tax-exempt investors should focus on. Each type of US tax exemption differs in scope and applicability.

Treaty Tax Exemption

The Treaty provides an exemption to US tax to Canadian religious, scientific, literary and charitable organizations that exempt from tax in Canada. The Treaty also provides a more limited exemption from US tax on dividends and interest to certain legal entities that provide pension, retirement, or employee benefits that are tax exempt in Canada. A collective investment vehicle made up solely of the investors listed above is exempt from US tax on dividends and interest. To take advantage of this, many Canadian investment firms operate pooled investment vehicles available solely to investors that qualify for the Treaty exemption. The Treaty exemption is beneficial in that it is quite simple to put in place. There are three notable limitations to the Treaty exemption. First, it does not apply to governmental entities. Second, the scope of the exemption for pension funds is limited to dividends and interest. Third, the exemption does not apply income generated from a trade or business or from a related party that is not tax exempt.

Tax exemption for Governments

Section 892 of the Internal Revenue Code (the US domestic tax law) exempts foreign governments and political subdivisions of those governments from US taxation. In the Canadian context, this would most obviously apply to Canadian federal and provincial governments. But it also may apply to other entities including municipalities, First Nations (under either a Treaty or the Indian Act), school boards, and other quasi-governmental agencies. Code section 892 also applies to pension funds formed by a governmental organization. The exemption under Code section 892 is quite broad and includes regular investment income, but it may also open up the opportunity to invest in US investment funds (such as real estate, infrastructure, and private equity) on a tax-free basis. Each US investment fund is different and requires complex analysis.

General tax exemption for non-profits

Certain Canadian non-profits fall outside the scope of the Treaty exemption. For instance, they may not qualify as a charitable organization as they are not a Canadian registered charity. These organizations, may however, qualify under the US domestic tax exemption available to non-profits. Code section 501(c) contains tax exemptions for 27 different types of non-profit entities. Many of these exemptions are available to foreign organizations. In particular, Code section 501(c)(4) applies to non-profit organizations that operate for the “promotion of social welfare.” This is a relatively broad category that goes beyond the Treaty exemption.

Exemption from US tax on real estate for pensions

There is a provision under US domestic law that exempts certain foreign pension funds that invest in US real estate, either directly or through a pooled investment entity, from US tax that goes beyond the exemption available in the Treaty. There are a variety of technical restrictions on what type of foreign pension qualifies. Still, this exemption is beneficial for Canadian pension plans looking to invest in US infrastructure or real estate projects or funds that invest in those projects.

Refund opportunities

Occasionally, a Canadian tax-exempt organization may not be aware that it qualifies for a US tax exemption. If it invests directly, it can apply to the IRS for a refund for three years of prior taxes paid. If it invests through a Canadian pooled fund that withholds tax on behalf of  investors that make up the fund. In such cases, a refund may be possible depending on certain technical criteria of the pooled fund and whether sufficient documentation is available to make the case that the tax was withheld on income earned by the fund, but that the income and the tax were allocated to the investors under US tax rules, and since the investors are tax-exempt, they should be eligible for a refund.

Conclusion

Although the Treaty exemption is the most straightforward US tax exemption for Canadian tax exempt organizations, it is worth noting that there are other exemptions from US tax that may be open to Canadian tax-exempt investors to take advantage of to increase their investment returns. In sum, the following types of organizations in Canada may be eligible for a US tax exemption:

  • Registered charities and foundations;
  • Educational organizations;
  • Religious organizations;
  • Scientific organizations;
  • Pension, employee benefit and retirement funds;
  • Non-profits even if they are not registered charities;
  • First Nations (either investing through a trust or directly);
  • Indigenous investment funds;
  • Municipalities;
  • Conservation Authorities;
  • Other quasi-governmental agencies created by federal or provincial legislation.

Written by Max Reed