Investors who own non-Canadian securities in their non-registered investment accounts need to be mindful that the favourable tax treatment often associated with a similar investment, had it been Canadian, may not materialize.
Consider dividends, which, if received from a Canadian company, are eligible for the dividend tax credit, which substantially lowers your effective tax rate on such income. Dividends from non-Canadian companies, however, are treated as foreign income and are taxed at full marginal rates, less any credit for foreign taxes withheld.
Similarly, if you invest in a Canadian mutual fund that distributes a capital gain, you will pay tax on only 50% of that gain. If the fund's distribution is classified as a "return of capital" (ROC), the amount received won't be immediately taxable but will instead reduce the adjusted cost base of your investment, resulting (hopefully!) in a deferred capital gain on ultimate disposition of the fund.
The tax treatment of a capital gains dividend and ROC received from a non-Canadian fund, however, is quite different and was the subject of tax case decided late last month.
In 2009, Hellmut Schmidt received a T5 from RBC Dominion which indicated he and his spouse had received foreign income of US$17,984 and foreign tax withheld at 15% of US$2,697, the bulk of which was attributed to his ownership of 23,000 units of the DNP Select Income Fund Inc. ("DNP").
DNP's website states that it is a U.S.-based closed-end management investment company whose primary objectives are current income and long-term growth of income.
Mr. Schmidt searched the Internet and found that DNP had not only distributed investment income in 2009 but had also distributed long-term capital gains as well as ROC. Prior to filing his 2009 tax return, Mr. Schmidt wrote to RBC Dominion requesting a "corrected T5 - which included the capital gains and return of capital." He received no response from RBC.
Based on the distributions per share reported by DNP on its website, Mr. Schmidt and his spouse reported only part of the dividend received as investment income, determining that nearly $7,000 of the income was ROC and, therefore, should not be subject to tax. In addition, he included only 50% of the capital gains portion of the dividend in their income.
The judge disagreed and held that the entire amounts received are fully taxable as foreign income, stating that Mr. Schmidt "has not presented any evidence that would allow me to conclude that the type of distributions made by DNP flowed through to him."
The Canada Revenue Agency's general guidance in this area states that "(i)t is a question of corporate law, not U.S. tax law, that will determine the nature of the cash distribution for Canadian tax purposes - Under U.S. tax law, certain distributions may be treated as a return of capital when in fact they are a dividend under corporate law" and thus properly taxed as a foreign dividend.