US Withholding Tax Refunds from Canadian Pooled Fund Investments - WTax

By guest author Max Reed. Max is a cross-border tax lawyer and the founding partner of Polaris Tax Council Canada. WTax partners with Polaris Tax Council in recovering US withholding tax for investors of Canadian pooled funds.

Many Canadian tax-exempt investors invest in US equities through a standard Canadian pooled fund. This means that they pay the 15% US dividend withholding tax on US equity investments. This can be refunded. To illustrate, assume that a Canadian charity invests in Apple stock through a standard Canadian pooled fund. When the dividend is issued by Apple to the pooled fund, the 15% US dividend withholding tax is collected by the pooled fund and sent to the US Internal Revenue Service (“IRS”). However, the charity itself is exempt from the US tax. That means that the charity can claim a refund. Over a three-year period, the amount of withholding tax paid to the IRS may amount to tens of thousands of dollars or more depending on the size of the US equity investment. The balance of this article explains the opportunity further. To start out, consider the different sources of the US tax exemption.

What Canadian organizations qualify for the US tax exemption?

There are a number of different sources of the US tax exemption. They are outlined below followed by a summary list of Canadian organizations eligible for the US tax exemption.

1. Treaty Tax Exemption
   The Treaty provides an exemption to US tax to Canadian religious, scientific, literary and charitable organizations that exempt from tax in Canada. The Treaty also provides a more limited exemption from US tax on dividends and interest to certain legal entities that provide pension, retirement, or employee benefits that are tax exempt in Canada.
2. Tax exemption for Governments
   Section 892 of the Internal Revenue Code (the US domestic tax law) exempts foreign governments and political subdivisions of those governments from US taxation. In the Canadian context, this would most obviously apply to Canadian federal and provincial governments. But it also may apply to other entities including municipalities, First Nations (under either a Treaty or the Indian Act), school boards, and other quasi-governmental agencies. Code section 892 also applies to pension funds formed by a governmental organization.
3. General tax exemption for non-profits
   Certain Canadian non-profits fall outside the scope of the Treaty exemption. For instance, they may not qualify as a charitable organization as they are not a Canadian registered charity. These organizations, may however, qualify under the US domestic tax exemption available to non-profits. Code section 501(c) contains tax exemptions for 27 different types of non-profit entities. Many of these exemptions are available to foreign organizations. In particular, Code section 501(c)(4) applies to non-profit organizations that operate for the “promotion of social welfare.” This is a relatively broad category that goes beyond the Treaty exemption.
4. Summary of eligible organizations
   In sum, the following types of organizations in Canada may be eligible for a US tax exemption:

    

   • Educational organizations;
   • Religious organizations;
   • Scientific organizations;
   • Pension, employee benefit and retirement funds;
   • Non-profits even if they are not registered charities;
   • First Nations (either investing through a trust or directly);
   • Indigenous investment funds;
   • Labour Unions
   • Municipalities;
   • Conservation Authorities;
   • Other quasi-governmental agencies created by federal or provincial legislation.

Investors in pooled funds can apply for a refund of US withholding tax

Many investors that are eligible for a US tax exemption invest through a pooled fund that pays the dividends withholding tax. There are a number of reasons for this. First, the investment manager may not offer a pooled fund that is exempt from US withholding tax. Second, the pool may be part of a global investment strategy of which US equities are a part and such funds are normally not exempt from withholding tax. Third, a segregated portfolio of US equities, where there would not be withholding tax, may not be advisable for a number of reasons.

A Canadian organization that invests through a pooled fund that collects the US withholding tax can apply for a refund for three years of taxes paid through the fund. Here is why. Arguably, for both US and Canadian tax purposes the US dividend withholding tax (although collected and remitted by the fund itself) is allocated to the investor and thus considered paid by the investor. For Canadian tax purposes, this is true under sections 104(22) and 104(22.1) of the Income Tax Act. For US tax purposes, the technical logic is more complicated. Even though most pooled funds are formed as trusts under Canadian law, they cannot be classified as a trusts under U.S. tax law because they have a business purpose. Assuming they meet certain technical criteria, the pooled funds may be partnerships under U.S. tax rules. If so, the withholding tax would be allocated to the investor under U.S. tax law as well. Since the investor does not owe the tax, with the proper documentation it can apply for a refund for the tax paid in the previous three years. That refund could result in reasonable amount of money as a refund.

The magnitude of US tax paid may be surprising

The amount of US dividend withholding tax paid through a pooled fund investment may be surprising. The standard dividend yield in the S & P 500 is 2.2% of the money invested. Of that, 15% is withheld in US taxes. That means that on a yearly basis the dividend withholding tax represents about a 33-basis point cost on the total dollar amount invested in US equities. On a large portfolio this can add up. The chart below illustrates the potential recovery over three years based on amounts invested in US equities.

Conclusion

Many Canadian tax-exempt organizations invest in US equities through pooled funds and thus pay the 15% US dividend withholding tax on their US equity portfolios. They can get a refund of this tax for the prior 3 years, which may amount to tens of thousands of dollars. In difficult economic times, every dollar counts.

To find out more about recovering US dividend withholding tax, contact Ian Filion, CIM® from WTax’s Toronto office at IanF@wtax.co.