Earlier this year, the Canada Revenue Agency (CRA) issued new forms that can be used by persons paying amounts to non-residents that are subject to Canadian withholding taxes. Use of the forms is not mandatory and, if the only development were the release of the forms, there would be little to remark upon. However, the CRA also announced the end of the "address rule" used by Canadian payers in determining their withholding obligations effective December 31, 2011 and new diligence requirements. This note considers Canada’s existing withholding regime, the proposed changes and the difficulties that Canadian payers will face in complying with these rules.
The Income Tax Act (Canada) (ITA) imposes a 25 per cent tax on certain payments made by Canadian residents to non-residents including interest, dividends, royalties and rents (referred to as Part XIII tax). In addition, a non-resident that disposes of "taxable Canadian property" is liable to tax under the ITA on any income or gain arising on the disposition and may be required to obtain a clearance certificate from the CRA under section 116 of the ITA (a section 116 certificate) by paying an amount on account of the non-resident’s tax liability. Recent amendments to the ITA have narrowed the scope of payments subject to Part XIII tax by excluding interest paid to an arm’s length person, where the interest is not "participating debt interest". In addition, the definition of taxable Canadian property has been narrowed including to exclude shares of a Canadian private company unless more than 50 per cent of the fair market of the shares was derived, directly or indirectly, from Canadian real property, resource property of timber property at any time in the preceding 60-month period.
As these taxes are imposed on non-residents, Canada imposes a withholding obligation. In the case of a person paying an amount subject to Part XIII tax, the payer is required to withhold the tax and remit it to the Receiver-General. If an agent for the non-resident receives an amount from which Part XIII tax should have been withheld without the withholding having been made, the agent is liable to make the withholding and remittance. A person who has failed to withhold Part XIII tax as required is liable to pay as tax on account of the non-resident the amount that should have been withheld (and is entitled to recover from the non-resident). A reporting obligation is imposed on persons paying amounts subject to Part XIII tax. In the case of taxable Canadian property, if a section 116 certificate is not delivered where required, the purchaser of the property is liable to pay 25 per cent of the purchase price on account of the non-resident vendor’s tax liability (and is entitled to recover from the vendor) unless the purchaser, after reasonable inquiry, had no reason to believe the vendor was not resident in Canada. It is noteworthy that a reasonable inquiry "defence" is expressly provided in the context of a section 116 certificate but not in the context of Part XIII tax. For the purposes of this note, it is assumed that a reasonable inquiry defence is not available for Part XIII tax but the point has not been definitively established by the Courts.
Penalties may be assessed against a payer where an amount is not withheld as required and interest is payable at a prescribed rate from the date amount should have been withheld to date of payment to the Receiver-General.
The ITA contains certain "fairness provisions" under which the Minister of National Revenue may waive or cancel all or part of a penalty or interest payable, but not an amount payable as tax.
The provisions of a bilateral tax treaty between Canada and another country may limit Canada’s ability to impose taxes on a person who is a resident of the other country for the purposes of the treaty. The treaty may require, as a condition of relief, that the recipient be the "beneficial owner" of the payment (in the case of interest, dividends and royalties) and, in the case of the Canada-United States tax treaty, satisfy a limitation on benefits provision. As a matter of administrative practice, Canada allows relief at source on payments otherwise subject to the 25 per cent Part XIII tax so that the payer may apply a lower rate of withholding. However, if a non-resident disposes of taxable Canadian property in respect of which a section 116 certificate is required, the non-resident must ordinarily apply for the certificate even if the gain is exempt from tax under the treaty although the CRA may issue the certificate without requiring any payment on the basis of the treaty exemption.
From the foregoing, it is apparent that a person making a payment that may be subject to Part XIII tax must determine if the recipient is a non-resident and, if so, is entitled to treaty benefits. Historically, the CRA relied on the so-called "address rule" under which the payer could accept the name and address of the payee as being that of the beneficial owner unless there is reasonable cause to suspect otherwise. The CRA provided a non-exhaustive list of circumstances that would give reasonable cause to question the beneficial owner: the payee is known to act, even occasionally, as an agent or nominee; the payee is reported "in care of" another person or "in trust"; or the mailing address provided for payment of interest or dividends is different from the registered address of the owner. The CRA permitted a financial intermediary located in a foreign country to apply the benefit of tax treaties between Canada and the beneficial owners’ residence countries on a pooled basis if the foreign intermediary certified beneficial ownership and country of residence to the CRA. Of interest, special rules apply in the case of payments to Swiss nominees — the Canada-Switzerland treaty rate can be withheld by a Canadian payer because if the beneficial owner is a resident of a third country, the nominee makes the additional withholding which is in turn paid to Canada through an arrangement with the Swiss government. These policies were set out in Information Circular IC 76-12R6, "Applicable Rate of Part XIII Tax on Amounts Paid or Credited to Persons in Countries with which Canada has a Tax Convention." However, the CRA did not exonerate a payer that followed the procedures set forth in the Circular but failed to withhold the correct amount. Rather, the Circular states that the payer is liable for any deficiency in the amount of tax that should have been withheld, penalties and interest.
Earlier this year, the CRA released three new forms that may be used to establish the identity of the beneficial owner of a payment. The base form is Form NR301—"Declaration of Eligibility for Benefits under a tax treaty for a Non-Resident Taxpayer." The other forms are Form NR302 — "Declaration of Eligibility for Benefits under a tax treaty for a Partnership with Non-Resident Partners" and Form NR303 — "Declaration of Eligibility for Benefits under a tax treaty for a Hybrid Entity." Form NR302 and Form NR303 are to be used by a partnership or hybrid entity (currently only relevant in the case of the Canada-United States tax treaty) to claim relief on some or all of a payment to be made by it based on the treaty eligibility of its partners or its members which would be established, in turn, through the provision of Form NR301 by each such partner or member.
Form NR301 requires that the payee completing the form provide information including its legal status, country of residence and the nature of payments to be received. The payee must certify that the information is true and correct, that the payee is the beneficial owner of the relevant payment and that, to the best of the its knowledge and based on the factual circumstances, it is entitled to the benefits of the relevant treaty on the relevant income (which implicitly takes into account the limitation on benefits rule in the Canada-United States tax treaty in the case of a resident of the United States). A completed form will expire on the earlier of a change in eligibility for treaty benefits, and three years from the year the form is signed and date. The form is delivered to the payer in the case of a payment subject to Part XIII tax. In the case of an application for a section 116 certificate, the form would be delivered to CRA along with the application. In the case of a partnership or hybrid entity, Forms NR302 or NR303 would also be used, as applicable, when applying for a waiver of withholding under Regulation 105 to the ITA in respect of fees, commissions and other amounts in respect of services performed by a non-resident in Canada.
If the only development were the release of the forms, there would be little to remark upon.
However, the CRA also released additional guidance with respect to the forms in "More Information on Forms NR301, NR302 and NR303" (April 19, 2011) and "Pending Update to IC 76-12 Related to Forms NR301, NR302 and NR303" (May 6, 2011). In the latter document, CRA announced a fundamental change to its previous policy and the end of the address rule effective as at the end of 2011. The CRA stated:
The payer must have recent and sufficient information to establish the identity of the beneficial owner for the purpose of the application of treaty benefits; whether they are resident in a particular country with which Canada has a tax treaty and whether they are eligible for treaty benefits under the tax treaty on the income being paid.
While forms NR301, NR302, and NR303 are not prescribed forms, the information they request is important for determining whether a tax treaty rate can be applied. Equivalent information can be accepted.
This represents a change from the Canada Revenue Agency's previous position that generally accepted the use of the payee's name and address for determining whether to apply treaty benefits. There will be a transition period until December 31, 2011, to allow payers to gather any additional information needed.
In addition, in "More Information on Forms NR301, NR302 and NR303," the CRA establishes a diligence requirement:
The payer should review the information provided by a non-resident on Form NR301, NR302, or NR303, or in another format, to make sure they have enough information to support that the non-resident is eligible for tax convention/treaty benefits on the income being paid.
To establish a withholding tax rate, the payer should question the information given and look at other information received from the non-resident, or known about the non-resident, if the payer knows or has reasonable cause to believe that the information on the form:
- is not correct or is misleading;
- contradicts information in the payer’s files; or
- is given without knowledge or consideration of the facts of a situation.
Readers may note some similarities with the rules applicable to a "qualified intermediary" for U.S. tax purposes.
Various industry organizations are expected to make submissions that the January 1, 2012 implementation date is too soon. Even if a payer elected not to obtain new forms from recipients of payments, it would still have to ensure that it has enough information to support that a non-resident payee is eligible for treaty benefits. It is not clear how a payer is to satisfy the requirement that the information given does not contradict other information in its files — does the reference to files mean all files, including paper files, or is it limited to electronically searchable files? In addition, payers such as financial intermediaries will have to put in place new account opening procedures to obtain the necessary information from payees on a going forward basis.
Industry submissions are expected to point out that the new CRA guidance does not expressly state that relief would be given under the "fairness provisions" from the imposition of a penalty and interest if a payer fails to withhold the correct amount but obtained the necessary form and performed appropriate due diligence.
There are a number of exceptions to the proposed changes including:
- a.Payments made to CDS Clearing and Depository Services Inc. (CDS) on securities registered in the name of Cede & Co. are to be made without withholding tax as tax is to be withheld by CDS based on information received from the Depository Trust Company (DTC) and collected by DTC's participants.
Reduced withholding tax may be applied by a payer without obtaining the forms or equivalent information regarding beneficial ownership, country of residence, and eligibility for treaty benefits if all of the following are true:
- The payer knows that the payee is an individual, or the payee is an estate and the trustee has an address in the United States.
- The payer has a complete permanent address on file that is not a post office box or care-of address.
- The payer has no contradictory information.
- The payer has no reason to suspect the information is inaccurate or misleading.
- The payer has procedures in place so that changes in the payee's information (for example, a change of address or contact information that includes a change in country, or returned mail) will result in a review of the withholding tax rate.
- The arrangements with Swiss nominees referred to above continue.
In addition, foreign intermediaries may continue to claim relief on a pooled basis on certifying that the income from specified property registered in its name is and will continue to be held solely for the beneficial ownership of persons resident and eligible to claim tax treaty benefits under a tax treaty that provides for a specified Canadian withholding tax rate on amounts paid or credited in respect of such property.
In summary, payers of amounts subject to Canadian withholding tax are expected by CRA to do more in determining the residential status and entitlement to treaty benefits of payees. These changes are directed primarily at Canadian payers to ensure that the benefits of Canadian tax treaties are given only to non-residents that are entitled to them. The new forms are intended to assist payers in so doing, however, payers need to remain vigilant as a completed form provides no protection if incorrect. It is likely that significant changes will be required to the procedures and systems of financial institutions to comply with these changes.
These changes are not unique but are part of a wider trend to enhanced tax withholding and reporting.
The Treaty Relief and Compliance Enhancement (TRACE) project of the Organisation for Economic Co-operation and Development, for example, contemplates a system in which financial intermediaries will enter into agreements with source states to become "authorized intermediaries." An authorized intermediary will collect a standardized "investor self-declaration" from investors relating to the investors’ residence and entitlements to treaty benefits. The authorized intermediary will be expected to perform certain due diligence in order to rely on an investor self-declaration. Authorized intermediaries will report payments and withholdings to the relevant source state. The TRACE proposals contemplate that a source state will exchange information with residence countries pursuant to exchange of information provisions in tax treaties to ensure that the amounts are being reported by investors in their residence countries.
The Foreign Account Tax Compliance Act (FATCA) regime to be implemented in the United States approaches the issue somewhat differently by requiring "foreign financial institutions" to report to the United States government with respect to accountholders that are U.S. persons and imposing a 30 per cent withholding requirement in respect of accounts of "recalcitrant" investors (i.e., if the institution cannot determine where or not the investor is a U.S. person). For details, see our March issue of the Tax Update.