Canadian Trusts
Trusts are legal entities that can pass its earnings to the unitholders without being taxed at the corporate level. To gain this tax benefit, Trusts are required to pay out most of their earnings as distributions to unitholders, resulting in large dividend yields. These trusts refer to their dividends as distributions.
Canadian Trusts can be found in many sectors but tend to focus on energy and real estate. Oil & Gas Trusts are commonly called Royalty Trusts, or, more informally, Canroys. Real estate trusts are called Canadian REITs.
What's the difference between Canadian and American Trusts?
American and Canadian trust are similar entity legally, but tend to operate differently. American trusts, particularly energy truts, aim at "milking" its assets through dividends. They usually avoid capital expenditures, nor do they tend to take on additional debt or equity financing. By comparison, Canadian trusts are often actively managed, will use debt and hedging, and are frequent and active acquirers. Thus, in many ways, Canadian trusts behave more like many limited partnerships than American-style trusts. The value of Canadian trust is somewhat tied to exchange rates, and the Canadian government has placed limitations on non-Canadian ownership. What's more, Canada takes additional taxes, such as a 15% foreign withholding (see taxation below). To compensate, those Canadian trusts that do trade in the U.S. often offer a higher yield.
Canadian REITs
Canadian REITs are nearly identical in structure to U.S. REITs.
The main difference is the absence of a "corporate veil" of liability protection. Theoretically, unitholders bear unlimited liability for the actions of a Canadian REIT. To minimize such liability, the REITs take out insurance policies on various aspects of the business, including environmental insurance. They also, to the extent possible, include language in loan contracts that specifically exclude their unitholders from liability of default.
There is also a foreign ownership restriction on all Canadian REITs of 49%. Should that limit be exceeded, the trustees of the REIT would decide, at their sole discretion, which foreign owners would be required to sell their shares.
The primary tax advantage of the REIT structure in both countries is the ability to pass on net income to the shareholders without taxation at the corporate level. Similar to American REITs, the Canadian versions must pay out a minimum percentage of their income to retain their tax-advantaged status. While American REITs must pay out at least 90%, Canadian REITs must pay out only 85%. This gives the Canadian REITs slightly more financial flexibility. And while most American REITs pay their dividends quarterly, there is a growing trend among Canadian REITs to switch to monthly payments, most having already done so. There is another tax advantage common to REITs of both countries, that of a portion of the dividends being non-taxable in the form of return of capital.
For longer term investors, business assessment of a Canadian and US REITs are similar. Accounting and financial reporting requirements are essentially the same. The key issue is of course currency risk.
Taxation of Canadian Trusts
Earning dividends from Canadian trust distributions qualify for the lower 15% dividend tax rate like for US corporation.
However, Canadian Trust dividends are subject to a withholding tax of usually 15% for US investors. You can apply for a refund for at least a portion of the amount withheld.
By virtue of a reciprocal tax treaty between the U.S. and Canada, the tax withholding amount is set as a percentage that varies by the type of income. For U.S. citizens receiving investment income from Canadian companies, Canadian withholding tax on interest income is set at 10%, while dividends and trust income are both taxed at 15% of the gross taxable amounts. This withholding tax applies to IRA accounts as well.
This Canadian income tax is withheld before the dividend, interest, or trust income payments are made to a U.S. investors. Payments follow the folowing process:
- The Canadian company pays all distributions to their transfer agent in one lump sum.
- The transfer agent withholds the Canadian income tax, paying it to the Canadian taxing authority, the CRA (Canada Revenue Agency), and forwards the remainder to CDS & Co. (Canadian Depository for Securities), the Canadian depository.
- CDS & Co. facilitates the border crossing of the payment, transferring it to either the Depository Trust Co. of New York, or CitiBank Clearing Corp., the U.S. depositories.
- The Depository Trust Co. of NY or CitiBank Clearing Corp. distributes the proportional amounts of the bulk payment to the U.S. brokers' clearing houses.
- The brokers' clearing houses pay the brokerage houses' customers (you) their share of the distributions. At the same time, the clearing house provides the distribution information to the brokerages (gross amount, taxes withheld, net amount, type of income.)
Because of the Treaty, you can claim a foreign tax credit on your tax declaration to avoid double taxation. However, this credit is limited to a lowly $300 yearly for single filers and $600 yearly for a couple. These limits apply to all foreign taxes paid in a tax year, not per country or per security. If the taxes exceed that amount, IRS Form 1116 must be filed with your U.S. tax return. That may or may not allow a full recapture of all of the foreign taxes you paid, depending on your particular tax situation.
Return of capital (ROC) dividends are not subject to withholding. But since most dividends will not be classified as ROC until after the end of the tax year, US taxpayer cannot claim it as a foreign tax credit on their return. The only recourse is to apply to the Canada Revenue Agency for a refund of that portion of the withholding that applies to the ROC.
