Investing in foreign property? Know the tax rules

Restrictions and Prohibitions
First off, administrators need to be aware that even though investment holdings in foreign assets may meet the pension plan’s governing legislation and Statement of Investment Policies and Procedures, they may not meet the rules and limitations that apply to investments held in registered pension plans (RPPs), as outlined in the Income Tax Act (ITA). Violating these tax rules could lead to de-registration of the plan and, consequently, denial of the tax exemption provided by the ITA. Failure to comply with the ITA requirements could lead to a fine of up to $25,000 and possible imprisonment for the plan administrator. (When an RPP is administered by a body of persons, the ITA imposes this penalty on each person who is a member of that body.)

The ITA generally restricts a pension plan from investing in a “prohibited investment” as well as investments that are not permitted by the Pension Benefits Standards Act, 1985 (PBSA). A prohibited investment includes shares of, an interest in or debt of the following:

(a) an employer that participates in the plan;
(b) a person “connected” with a participating employer;
(c) a pension plan member;
(d) any person or partnership that controls the aforementioned persons;
(e) any person or partnership that is not at arm’s length from the persons referred to in points (a) to (d); and
(f) interest in or rights to acquire such shares, interests or debt.

A person “connected” with an employer includes anyone who directly or indirectly owns 10% or more of any class of shares of the employer or a corporation related to the employer, or who does not deal at arm’s length with the employer. However, there are exceptions for certain investments, such as shares and debt listed on a designated stock exchange, which generally includes major stock exchanges of a number of countries. (A list is provided on the Department of Finance Canada website.)

Although it may be rare for a foreign investment fund to invest in a Canadian plan sponsor or other persons referred to above, it’s not uncommon for foreign funds to invest in Canada. For example, there are a number of Canadian pension plans that invest in certain U.S. funds that hold Canadian assets in their portfolio of investments. Accordingly, a pension plan’s legal counsel should work with tax advisors to ensure that plan administrators and fund managers enter into an agreement that restricts the type of investments that can be made in the plan. The agreement must ensure that administrators receive adequate notice prior to an investment, and administrators should monitor the foreign fund’s investments on an ongoing basis to ensure that any anticipated investments don’t fall into the prohibited category.

Pension plan administrators should also consider whether to hold foreign investments directly or through a corporation. For example, it may be prudent to use a pension corporation to limit a plan’s exposure to any tax compliance requirements in the foreign jurisdiction. The ITA exempts corporations involved with pension fund administration and investments from tax, provided that certain conditions are satisfied. These conditions relate to the ownership of the corporation’s shares, the activities that may be carried on, the investments made by the corporation and the use of borrowed funds. Corporations may qualify for the tax exemption if they:

• were incorporated before Nov. 17, 1978, solely in connection with, or to administer, an RPP;
• limit their activities to investing in real property or investments allowed under the PBSA; and
• made no investments other than investments permitted under the PBSA (with at least 98% of the assets being cash and investments), had not accepted deposits or issued certain obligations, and derived at least 98% of their income from investments or the disposition of investments.

Investors should consult tax advisors to ensure that corporations meet the required conditions stipulated in the ITA.

Are You Exempt?
Although pension plans are exempt from Canadian tax, foreign tax legislation or tax treaties with various countries may not provide for a tax exemption in the foreign jurisdiction. With a Canadian tax exemption, pension plans are unable to claim foreign tax credits in respect of foreign taxes paid—meaning that any foreign tax will result in a reduced return on investment (ROI). Therefore, plan administrators need to understand foreign tax implications, including foreign tax compliance, and take any possible steps to minimize the foreign tax effect on the rate of return.

Canada’s tax treaties generally provide for a reduction in or exemption from withholding tax in certain cases. Plan administrators must confirm that Canada has a tax treaty with the jurisdiction in which they’re considering investing and determine whether the treaty provides for tax benefits on the type of income they’ll receive. For example, Canada’s treaty with the U.S. provides for a withholding tax exemption on income such as dividends and interest received by a pension plan, but it does not provide relief from U.S. tax on effectively connected income (ECI)— that is, income from sources within the U.S. connected with the conduct of a trade or business.

When a Canadian pension plan invests in a U.S. fund that is considered a partnership, and that partnership holds an infrastructure asset (e.g., a toll road), the Canadian plan may be seen as being engaged in a U.S. trade or business (i.e., operating that toll road). If this is the case, the Canadian plan must file a U.S. income tax return and pay U.S. income tax on its share of the ECI. But this is costly, as U.S. federal and state taxes could exceed 40%, resulting in a significant hit to the ROI. It is also important to confirm that, in cases where a treaty exempts a pension plan from withholding tax, the same exemption applies to a pension corporation. As discussed above, a pension plan can invest either directly or through a pension corporation. Canada’s treaty with the U.S. specifically provides that the withholding tax exemption referred to above applies to both pension plans and pension corporations.

Where Canada does not have a tax treaty with the relevant foreign jurisdiction, plan administrators need to understand the foreign tax implications of the income. It may not always be necessary to rely on a treaty for exemption from foreign tax, as the foreign jurisdiction’s domestic legislation could provide tax relief. In such cases, plan administrators should consult tax advisors in the foreign jurisdiction to determine the tax implications.

Foreign tax consequences may also arise from the nature of the foreign assets. Except in the case of real property or investments that derive their value from real property (e.g., shares in a company whose assets are primarily composed of real property), most of Canada’s treaties provide for the taxation of capital gains in the country of the investor’s residence. Therefore, a gain from an investment in a foreign entity may only be subject to taxation in Canada—which, in the case of a Canadian pension plan, should be tax exempt.

When dealing with foreign real property interests, however, it’s usually more difficult to mitigate tax consequences. For example, Canadian pension plans are subject to tax on the disposition of U.S. real property under the U.S. Foreign Investment in Real Property Tax Act. Earlier this year, the Obama administration announced its plan to encourage investment in infrastructure projects. Under this plan, the administration proposes to exempt foreign pension plans from U.S. tax on gains from the disposition of U.S. real property interests, including infrastructure and other U.S. real estate assets.

Another consideration is the form or structure of the investment. The tax implications of investing in foreign debt, shares of a foreign corporation, a foreign partnership or a hybrid entity (i.e., an entity considered a corporation in one jurisdiction but a partnership or branch in another) may not be the same. For example, if a pension plan invests in a partnership, the income of the partnership is generally allocated to the partners (which includes the plan). The tax consequences of the income allocation may depend on the type of income earned by the partnership. As noted previously, a Canadian pension plan should not be subject to withholding tax on dividends or interest received from a U.S. partnership (because of the treaty exemption), but it would be subject to U.S. tax on ECI because the plan would be seen as engaged in a U.S. trade or business. In this case, U.S. tax compliance requirements would also be imposed on the pension plan.

It’s important to consult tax advisors on ways to limit a pension plan’s tax compliance exposure. One way is to interpose an entity (often referred to as a “blocker”) between the pension plan and the foreign investment to block certain types of income from flowing to the plan and shift the U.S. tax compliance requirements to the blocker.

In the agreement between the plan administrator and fund managers, plan administrators may want to have some flexibility in the structure of the investment. For example, if a foreign fund anticipates investing in Canada, the plan administrator would likely prefer—given the exemption from Canadian tax—to invest directly in the Canadian investment rather than indirectly through the foreign fund or blocker.

There is no doubt that pension plan administrators have a multitude of tax matters to consider when investing in foreign assets. Due diligence to make sure that investments meet ITA requirements on an ongoing basis, as well as guidance from legal counsel and tax advisors, is key in ensuring that the plan administrator is fulfilling its fiduciary duty. These actions may not only reduce tax compliance requirements but may also provide tax savings opportunities and, ultimately, increase investment returns.

Aly Lallani is a senior tax manager with BDO Canada LLP. alallani@bdo.ca

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