Non-Resident Tax:
A Sleeping Bear with a Big Bite.
As a real estate lawyer, I was happy to have one of my favourite realtors send me a new deal where I would be the seller’s lawyer. The first sign of trouble was a big add-on clause that confirmed the sellers were non-residents of Canada. “Uh-oh, could be trouble,” was my first reaction. Then I thought, “if the contract is making a special note that the sellers are non-residents, maybe they have the non-resident tax thing under control…?” When I chatted with the sellers and asked the question, no such luck. They knew nothing about any Canadian tax they might have to pay as non-residents and, in fact, had done nothing about tax of any kind in the 12 years they had owned the property. Now I’m really concerned and here’s why.
Background: Here’s a brief summary of a complicated situation.
If a non-resident of Canada sells their taxable Canadian property, there are huge tax implications for the seller as well as the buyer. There are similarly huge liability implications for realtors. For the most part, taxable Canadian property is real property located in Canada commonly referred to as real estate. However, be aware that included under the umbrella of taxable Canadian property are shares of a private Canadian company, capital property used in your Canadian business, as well as Canadian resource properties. Less common categories are shares in foreign corporations or interests in foreign partnerships and trusts that may require payment by a Canadian withholding tax.
On January 1, 2009, new rules came into effect intended to smooth out and speed up tax compliance for non-resident transactions protected from Canadian tax by treaties. If the transaction fits under the new rules, then a buyer is not liable for withholding tax. This is favourable for sellers as well since they get all their cash on closing. But, as often happens with rules intended to simplify a complex situation, the solution remains complex. If you think you have a transaction that might fit under the new rules, consult your tax professional as early as possible. These matters are best sorted out in the negotiation stage of any purchase and sale.
We are going to look at this issue mainly from the real estate side because real estate that includes land and buildings is usually not exempt from Canadian tax under our Canadian tax treaties.
Briefly, here’s how withholding tax works as applied to real estate.
Buyers: A buyer purchasing Canadian real estate from a non-resident has an obligation to withhold and remit to Canada Revenue Agency (CRA) 25% of the gross sale proceeds. Make a note; this is the gross sale proceeds, no deductions allowed. This liability increases to 50% where the real estate was depreciable property (a building used for rental or business purposes) or where the real estate was not held by the non-resident as capital property (for example, held for speculative purposes). A purchaser who fails to withhold this tax is liable for it unless they had no reason to believe the seller was a non-resident. And, make no mistake; the CRA has the ability to enforce this liability.
Sellers: Up to 50% of the gross sale proceeds, that’s a lot of money. What can the seller do? The withholding tax requirements can be reduced or eliminated if the seller obtains a ‘Certificate of Compliance’ (also often referred to as a ‘Clearance Certificate’) from the CRA. This process requires the filing of a form with CRA in advance of the sale or within 10 days thereafter, together with evidence as to what the sale proceeds are along with the seller’s acquisition costs (often referred to as the seller’s ‘Adjusted Cost Base.’ Properly done, the CRA will allow the withholding tax to be calculated at 25% (or 50% as applicable) of the gross sale proceeds less the cost of the property. This makes a huge difference in the withholding tax calculation.
By way of example, if the sale price is $400,000 on a rental property, the buyer’s hold back is 50% of the gross sale proceeds, which equals $200,000! If the seller paid $350,000 when he bought the property, then the basic calculation for the Certificate of Compliance is sale price of $400,000 minus purchase price of $350,000 times 50% equals $25,000. $200,000 versus $25,000; it’s an unbelievably huge difference. Then, when the seller pays the appropriate withholding tax, in this case $25,000, the CRA will issue a Certificate of Compliance.
Note: This process or calculation relates to withholding tax only. To figure out the actual Canadian income tax liability the seller must file a Canadian tax return by April 30 of the following year (for personal returns, corporate is due on their year-end). That return often results in a refund of tax to the seller as the withholding tax rate typically is higher than the actual tax liability. Why? Because costs of sale include real estate commissions, legal fees, and any other appropriate expenses, which reduce taxes payable on the return, whereas they do not reduce the withholding tax payable for Certificate of Compliance purposes.
To summarize using our example, here are the sellers three positions going from worst to best:
- On a sale of a rental property at $400,000, no Certificate of Compliance, withholding tax is $200,000
- Same property, purchase price of $350,000, Certificate of Compliance withholding tax is $25,000
- Same property, file a tax return, use all your deductions, final, actual tax is much less than $25,000
Realtor Issues
Reputation: your reputation will suffer if you know or ought to have known that the seller is a non-resident and you ignore that non-resident status or fail to advise the seller of the implications of being a non-resident.
Commission: if the buyer withholds tax, there is a good chance your commission cheque will be delayed. If a seller’s new purchase fails because of a withholding tax issue, you may not earn a commission cheque on the new deal.
Liability: the seller might sue you if you fail to bring non-resident tax issues to their attention and the seller suffers damages. If you act as the seller’s agent, collect rent, and you fail to remit the yearly rental withholding tax, you are liable for the withholding tax.
Buyer Issues
As a result of the liability that could apply for failing to withhold from a non-resident seller, buyers should always make reasonable inquiries to determine whether the seller is a non-resident. If the buyer has made reasonable inquiries and has no reason to believe the seller is a non-resident of Canada, then the buyer need not withhold. However, if there is any question about the residence of the seller, the buyer should withhold tax from the purchase price.
Note: it’s whether the seller is a non-resident not whether they are Canadian. You can be Canadian and still be a non-resident. Watch for this.
So, what is a reasonable inquiry?
Is it enough that the seller warrants in the real estate purchase contract that he is “not a non-resident for purposes of the Income Tax Act?” Seems pretty reasonable, it’s a warranty. How about if the seller’s lawyer provides further assurance that the seller is, “not a non-resident?” Usually, one or both of these warranties or assurances will cover off the buyer’s liability. However, if the buyer knows or ought to have known that despite the seller’s warranties and statements that the seller is actually a non-resident, then the buyer will likely be liable for the tax. If a buyer has any reason whatsoever to think the seller is a non-resident then the buyer should immediately bring it to his/her lawyer’s attention and insist on the appropriate withholding tax.
Seller Issues
Sellers have lots of issues being a non-resident.
Time: Certificates of Compliance can take well upwards of three months to obtain from the CRA after submission of all required documentation. It’s the rare seller who has that amount of time between his/her sale going unconditional and the completion date.
Payouts: if the seller is a non-resident on a $400,000 sale where the withholding tax is 50% of the gross sale proceeds, that means $200,000 is being held back by the buyer! If the seller has a $300,000 mortgage then, on closing, the seller can’t payout his/her mortgage, which will continue to accrue interest and payment responsibilities.
Need for Sale Proceeds: many sellers purchase a new property based on receiving full sale proceeds. Buyer’s withholding tax could jeopardize that new purchase.
Rental Income: The non-resident seller is also obligated to pay yearly withholding tax as a specified percentage (usually 25%) of the gross rents received. Typically the seller will hire a Canadian agent to collect the rents and remit then to CRA on their behalf. Realtors often act as property managers and agents.
What About My Clients in this Tale?
We started working on the tax aspects of their deal two months ago. The deal has closed and all of their net sale proceeds are held in trust until their accountant files 12 years of tax returns. They won’t know their final bill until the CRA decides whether or not to levy interest, penalties, or impose other sanctions for ignoring the Tax Act. This could take another six months depending on how busy the CRA is and how tough they want to be on my clients. Not a good situation.
Contact Barry McGuire now.
Alberta real estate needs an Alberta lawyer.
“Tax” image by Phillip Ingham on Flickr. Used under Creative Commons Attribution-NoDerivs 2.0