Michael Dolson is a tax lawyer at Felesky Flynn LLP in Edmonton.
My colleagues and I were very interested to read this week's articles in The Globe and Mail about the taxation of foreign investment in Canadian real estate. The quantum of foreign investment in Canadian real estate and the reasons for that investment are fascinating questions, but we do not think that foreign investment is a story about Canadian tax. In our view, the Canadian rules for taxing inbound investment are working exactly as they should.
At a conceptual level, it is useful to understand how Canada taxes income earned by individuals, including capital gains from real estate. Canada can impose tax on two bases: worldwide income of individuals resident in Canada, and Canadian-source income of non-resident individuals. If an individual is not a Canadian resident ("foreign," if you will), Canada can tax him or her only on income earned in Canada, and not on income earned elsewhere.
The limitation of Canada's ability to tax non-resident individuals to Canadian-source income is not a design flaw. Most other countries have similar rules, and our tax treaties with those countries restrict the right of foreign countries to tax Canadian residents on income that is not earned from sources in the foreign country. While there are academic arguments about how a source of income should be defined or located under Canadian law and tax treaties, it is clear that limitations on taxing powers prevent individuals – including Canadians – from being subject to tax in countries that have no connection to the income earned.
Viewed in this light, it is unsurprising that people who do not live in Canada pay little, if any, tax in Canada on income that has minimal connection with Canada. If these individuals are non-residents for tax purposes, which is usually the case, they need only report and pay tax on their income earned in Canada. Hong Kong or Shanghai-based businessmen who own houses in Vancouver not paying tax on their foreign business income in Canada is the right result, for the same reason that a Canadian businesswoman should not pay tax in the United States on her Canadian business income just because she owns a house in Phoenix.
Income or capital gains from real estate are Canadian-source income in almost all cases, and Canada has robust rules for taxing that income. Canada imposes withholding taxes on both rents payable to non-residents and on sale proceeds received by non-residents; these withholding taxes apply not only to direct sales of land, but also to sales by non-residents of interests in corporations, partnerships or trusts that derive most of their value from Canadian real property. To ensure that the tax is collected, liability for withholding and remitting the tax is imposed on the buyer of the land, shares or interest if they do not comply with the withholding requirements.
Subject to narrow exceptions in some of our tax treaties, the withholding regime means that it is unlikely that non-residents who own Canadian commercial real estate or residential rental real estate will be able to escape Canadian income tax on any rents or realized capital gains. This is true whether the property is owned directly or through a corporation, partnership or trust.
Some potential for tax avoidance may exist in relation to residential property that is owned by a Canadian-resident spouse or child of a non-resident who paid for the property and used as a principal residence of the spouse or child. Tax can be avoided in these situations because Canada made a deliberate policy decision not to tax capital gains on principal residences, regardless of the identity or residence of the person who provided the funds for the purchase. The principal residence exemption creates avoidance opportunities for both Canadian residents and non-residents equally, so this is best viewed as a problem with Canada's tax policy in general and not Canada's system of taxing non-resident investments.
From a tax practitioner's perspective, Canada's rules for taxing non-resident real estate investors are generally not in need of revision, and the Canada Revenue Agency is adequately empowered to enforce the rules. Non-resident investment in Canadian real estate is probably not tax-driven, as Canada taxes the gains on those investments in a way that is both fair and in accordance with international norms.